Investor Returns vs. Market Returns

A healthy dose of skepticism toward the media and its reporting on financial matters and markets is a common theme in our thought pieces. A quick analysis of the return data routinely provided by the financial media shows how misleading this reporting can be. In fact, investor returns are almost guaranteed to be different from whatever the markets and the funds you've invested in have reported.

How is this possible? Start with cash flows. We are told that the S&P 500 has delivered a compounded return of about 7.8% from 1992 through 2011, which sounds pretty positive until you realize that this return would only be available to someone who invested all his or her money at the beginning of 1992 and didn't move that money around at all for the next twenty years. If you invested systematically, the same amount every month, as most of us do, then you would have earned a 3.2% compounded return. Why? A lot of your money would have been exposed to the 2008 downturn, and not much of it would have enjoyed the dramatic run-up in stocks from 1992 to 2000.

Furthermore, there is the difference between investor returns and investment returns. Human nature drives investors to sell their stocks and move to the sidelines after their portfolios have experienced losses--which is often the worst possible time to sell. And it drives people to increase their equity allocations toward the peak of bull markets when they perceive that they are missing out on a rally.

That means less of their money tends to be exposed to stocks when the market turns from bearish to bullish, and more is exposed when markets switch from bullish to bearish. With the disciplined investing strategy of asset class re-balancing, we believe this approach removes the emotional component of investment management and market-timing to mitigate the “herd-mentality” results. The success of this strategy, however, depends in part upon properly setting aside capital for your short and medium-term goals.

This herd-mentality would be bad enough, but people also periodically switch their mutual fund and stock holdings. When a great fund hits a rough patch, there's a tendency to sell these “dogs” and buy a fund that whose recent returns have been performing. Many times the underperforming fund will reverse course, while the “hot” fund begins to lag. Morningstar now calculates the difference between the returns of its analyzed mutual funds and the average returns of the investors in those funds, and the differences can be astonishing. Overall, according to Morningstar and a third party annual report, investor returns have historically been about half of what the markets and funds are reporting.

A final but just as important component of the returns not accounted for by the media is federal and state taxes. If a mutual fund is sitting on significant losses when one invests, gains are achieved without having a material tax impact. If a given fund is sitting on large gains when an investor buys in, one could pay taxes even if the fund loses money. We believe tax efficient investing should be a top priority for individual investors, and we’d be happy to discuss our approach and the methods we have developed in order to mitigate the impact of taxes.

As you begin to think about year-end tax planning, feel free to reach out to us to discuss your concerns – we are happy to help, and wish you well during the upcoming holiday season.