The number one mistake investors make is the habit of chasing recent winners. People will inexorably move their money to an investment that has done well in the recent past. The grass always seems greener somewhere else, and we are constantly tempted to move across the street.

This phenomenon of chasing returns produces an apparent paradox. Investors do not earn, as a group, the same returns as are reported by the very mutual funds in which they invest and by the market indices. If a market index, such as the S&P 500, produces a given amount of return over some period of time, the entire collection of people that actually invest in the market never earn as high an amount, even after adjusting for fees. How can this be so? I can give you a simple example that explains the paradox.

Let's imagine there are only two stock funds, the Early Fund and the Late Fund. They start a given year with the same amount of investor money. For the first half of the year, the Early Fund earns 15%, and the Late Fund loses 5%. The investors all gather out in the cul de sac on July 1st and compare notes. The Early Fund investors are happy; the Late Fund investors are not so happy. All of the Early Fund investors stay in their fund and half of the Late Fund investors move to the Early Fund.

In the second half of the year, the Early Fund loses 5% and the Late Fund earns 15%. Let's stop here for a moment, because year-end is when fund companies report results and all the magazines rank mutual funds. How do Early Fund and Late Fund compare? Their reported results are identical. They each earned a compounded rate of return of 9.2%, and experienced the same degree of volatility, or risk. In our little universe of two funds, the entire market basket of available stock funds earned 9.2%.

But, hold on a moment. Isn't the point of investing to make money for investors? Let's see how our universe of investors did. By shifting money to the first half's winning fund, investors that started the year in the Late Fund missed a strong second half. So, while the Late Fund reported great results, the amount of money invested in the fund had shrunk by half. Where did that money go? Over to the Early Fund where it lost 5% in the second half.

What is the bottom line for the collective group of investors? They earned only 4.5%, or less than half the market return. Again, it can seem puzzling that investors, in aggregate, can make less than the return reported by the entire market. Investors, as a whole, do not earn the market average return. And, if I may say so, it's their own darn fault.

From 1984 through 2002, the collective universe of stock mutual funds earned about 11.0% annualized. The universe of investors in those same mutual funds earned an annualized return of only 2.6%. In dollar terms, the average investor starting with $100,000 in 1984 gave up a whopping $500,000 in investment gains due to the destructive habit of chasing returns.

Remember, this shortfall is not due to "bad mutual fund managers." The mutual fund managers, as a group, did just fine. The source of the investors' disappointing results can be found in their own bathroom mirror.

–Rick Ashburn, CFA, is Chief Investment Officer of Creekside Partners Investment Counsel in Lafayette, California. He has managed investments for institutional and private clients for 23 years. Visit his website at creeksidepartners.com, or e-mail him at rick [at] creeksidepartners [dot] com.

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posted at 08:44:48 PM