How and Why Investors Lose

How and Why Investors Lose

How and Why Investors Lose

The table below titled, "Average Mutual Fund vs. Average Fund Investor" illustrates some of the details of the Trzcinka study cited by Jason Zweig. The large gap between the funds' and shareholders' returns was a shock to even the researchers. The reason for this gap is attributed to active investors who followed the destructive behavioral patterns that Dalbar Research had been describing since 1994. These patterns include waiting for funds to have a good year or two followed by pouring in a flood of cash just before the fund reaches its peak. Then they ride the fund to near bottom and sell.

One encouraging exception was the Dimensional Fund Advisors (DFA) institutional index funds. DFA investors are limited to either large institutional investors or individuals who have been educated by specially trained investment advisors. Because the shareholders of these funds buy and hold diversified portfolios at all times, they ride out the market gyrations and end up obtaining market rates of returns. The table below shows the worst big funds ranked by how investors performed relative to the funds and five DFA funds listed in the article.

As an example of a fund that earned high returns yet managed to destroy wealth, the CGM Focus Fund (CGMFX) racked up an impressive annualized return of 13.00% from 1999 to 2012. However, the investor return over this period was a devastating annualized 5.09% loss. In total it was estimated that investors lost over $1 billion in this fund over this period, while the fund reported time-weighted returns of 13.00%. CGM Focus Fund earned fantastic returns for a relative handful of early investors. But fund's late, giant losses were shared by many more. A careful analysis of the chart below will reveal the tragedy of active investors’ behavior.

Back in 2006, Morningstar posted a short article on the differences between what funds earned and what investors earned. The article found further evidence that investors chase returns and that this behavior goes against their best interest.

A few definitions may help in the understanding of the differences between dollar-weighted returns and time-weighted returns.

Holding Period Return: The percent change in a portfolio’s total market value over a given period. It is a single-period version of Dollar-Weighted Return.

Dollar-Weighted Rate of Return: Dollar-weighted rate of return, or “DWRR” for short, is also known as "Internal Rate of Return" or simply "IRR." It is used to determine the rate of return on an investment that has variance in cash flows. It is useful in determining the results of chasing fund returns overtime and provides an average "investor return" of mutual funds over a specified period, in contrast to just the change in price of the investment over time, which is the time-weighted return. IRR equates the present value of an investment's cash inflows (dividends, interest, and sales proceeds received) or outflows with the present cost of the investment. That is, for an investment that has a number of cash inflows or outflows over time, the IRR is defined to be the discount rate that makes the net present value of those cash flows equal to zero. Stated another way, the IRR is “…the interest rate that will make the present value of the cash flows from all the sub-periods in the evaluation period plus the terminal market value of the portfolio equal to the initial market value of the portfolio.” (Fabozzi, Frank J., Fixed Income Mathematics, ©1993 1997, pp 157)

Time-Weighted Rate of Return: A time-weighted rate of return measures the return of an investment over a certain holding period. The average investor in the investment may have waited until after the investment did well, then added lots of capital, only to be heavily invested during the decline, thereby having an average dollar-weighted return substantially below the reported time-weighted return. The opposite flows would create dollar weighted returns in excess of the time weighted returns. Cash flows moving in and out of the investment do not affect the time-weighted rate of return (unlike with dollar-weighted rates of return or “IRR”).

On the Data Definition page of their web site, they state that "Morningstar investor returns (also known as dollar-weighted returns) measure how the typical investor in that fund fared over time, incorporating the impact of cash inflows and outflows from purchases and sales. In contrast to total returns, investor returns account for all cash flows into and out of the fund to measure how the average investor performed over time. Investor return is calculated in a similar manner as internal rate of return. Investor return measures the compound growth rate in the value of all dollars invested in the fund over the evaluation period. Investor return is the growth rate that will link the beginning total net assets plus all intermediate cash flows to the ending total net assets."

A related paper is titled, Behavioral Portfolio Analysis of Individual Investors, by A. O. I. Hoffmann and Joost M.E. Pennings of University of Maastricht - School of Business and Economics - Department of Finance and Hersh Shefrin of Santa Clara University - Leavey School of Business and the National Bureau of Economic Research (NBER) (published June 24, 2010). In the abstract they state, "In line with our expectations, we find that investors driven by objectives related to speculation have higher aspirations and turnover, take more risk, judge themselves to be more advanced, and underperform relative to investors driven by the need to build a financial buffer or save for retirement."

Russ Kinnel from Morningstar wrote another article on how Bad Timing Eats Away at Investor Returns on Feb. 15, 2010. In the article Mr. Kinnel explained how Investor Returns are calculated: "Investor returns tell you how the average investor in a fund fared. We take monthly cash inflows and outflows and then calculate the returns earned on those flows. As with an internal rate of return calculation, investor return is the constant monthly rate of return that makes the beginning assets equal to the ending assets with all monthly cash flows accounted for. The gap between investor returns and total returns shows you how well investors timed their purchases and sales. (For all the details on the calculation, you can check out the two-page fact sheet here or the 10-page methodology document here.)"

The conclusion of the analysis of the first decade of the new millennium was that "the whipsaw of the past two years has meant that, in most categories and in the aggregate, investors have done worse than the average fund. ... The grand total for the average investor in all funds in the aughts was a 1.68% annualized return, compared with 3.18% for the average fund." That meant that the average investor only captured 53% of the average funds total return. See the details here. Note that among US Equity Funds, investors only captured 14% of the 1.59% total return of the decade.

To compare this data with the IFA Index Portfolios, see here, and for a sample client over most of this period see here.