Mutual Fund Investing to Get Market Returns

blackberriesMost people do not get market returns when investing in mutual funds, even though they own so many different stocks through those funds that they should be nearly matching the market.  This means that while the stock market may return 10-15% over long periods of time, your returns may be only 5%. Instead of doubling every five to seven years, your portfolio value will double every twelve years.  As a result of lower returns, you will have hundreds of thousands of dollars less by the time you reach retirement.

There are two things that cause your portfolio to lag the market.  One of them is purely due to your behavior.  The second may very well be within your control.  These things are 1) trying to time the market or pick the hot funds and 2) fees and taxes on investments.

Buy in and stay in.

The biggest reason people lag the markets is because they sell stocks and miss out on a big rally, then buy stocks after they have had a big run-up, just before they fall back. This is caused by the way people select mutual funds.  They look at returns over the last year or the last five years and buy the ones that have had the best return.  Alternatively, they use a rating system like Morningstar or a list of the “best funds,” both of which designations usually mean that the fund has done well over the last several years.  People also tend to sell their funds and switch into the funds that have outperformed theirs.

When a fund has done well, it means that the stocks it holds have increased in price, meaning that a lot of them are high relative to their normal valuations.  Likewise, a fund that has not done well likely has a lot of stocks that are bargains compared to their fair market value.  This means that people are selling stocks when they are cheap and buying them when they are expensive.  Do this year after year and you’ll see your portfolio returns lag the market returns.

Instead, you should be buying funds strictly based on allocation of your money to different sectors of the markets.  This is based mainly on your age or, more accurately, how long it will be before you will need to start using some of the money in your portfolio.  Since most people are investing for their retirement, they need to look at how long they have before retirement and use that as a guide to allocation of their money.  Someone investing for college or some other event should allocate based on time until that event.  A good allocation for someone saving for retirement with 30 years to go would be:

30% in a small cap fund

30% in a large growth stock fund

15% in an international stock fund

15% in a value stock fund

10% in an REIT fund

Someone who was five years from retirement might allocate as follows:

5% bank CDs

40 % in a bond fund

10% in an REIT fund

10% in an international stock fund

30% in a large cap stock fund

5% in a small cap growth fund

These allocations are made only based on investment time frame – how long you have to invest – and on the amount of risk the investor can withstand, given life circumstances.  Once invested, you don’t shift to one sector of the market or another because it does well.  In fact, you adjust the amount you have in each sector to maintain your allocations.  This means that if small growth stocks do well one year, you would sell some portion of that fund and direct your investments into the other funds that didn’t do as well.  If you are investing in a taxable account, such that sales of winners would generate capital gains taxes, you could also just shift your future allocations in the funds that are under-represented in your portfolio instead of selling and moving money from fund to fund.

Minimize fees and expenses.

The other reason people lag the market is due to fees and expenses.  If you have the choice between two different funds that invest in the same portion of the markets, realize that because the funds are buying so many different assets that their returns before fees and expenses will basically just match the returns of the markets.  This means that a fund that charges a fee of 1.5% a year will have a return that is 1% less than one that charges 0.5% per year.  While this may not seem like a lot, realize that every dollar you pay in fees when you’re in your 20’s will result in about $120 less in your portfolio when you retire.

The first way to minimize fees is to choose passive funds over actively managed funds.  The active funds have a team of managers who spend their days choosing stocks or bonds, travelling to meet with corporate boards, and sitting in large conference rooms, swilling lattes that you are probably paying for as an investor.  Instead, choose a passive fund like an index fund or an ETF that uses a pre-defined strategy for choosing stocks.  For example, an index fund would just buy whatever is in the index it is designed to track.  Because there are less decisions to make,  and because you don’t have a manager there constantly selling and buying securities in an effort to try to beat the markets, these funds can have really low fees.  In fact, recent competition in some of the building block funds like S&P500 funds have resulted in the cost for these funds dropping to a few dollars per $10,000 invested per year.

The seconds way to reduce fees and expenses is to be very passive in the way you handle your portfolio.  While it makes sense to rebalance your portfolio about once a year to shift money from sectors of the markets that have done well into those that have not done as well, too much churning drives up the costs for the funds you invest in, which in turn increases your fees.  If you are investing in a brokerage account and buying ETFs, you’ll pay a commission on each transaction.  In addition, you may generate capital gains taxes if you’re in a taxable account.  All of these things pull money out of your portfolio, reducing the amount of money you have available to compound and grow.

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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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