The Penalties of Being an Emotional Investor

We've already established, through previous blog posts, that Mutual Funds, over the long-term, underperform Index funds. As an investor, it's more beneficial to invest in Index funds and get the average return of the market as opposed to trying to beat the market because we can avoid the high fees that then eat into our profits.

The false promises and underperformance of mutual funds are not worth it. But, let's say, for argument's sake, we did invest our money into mutual funds and let's say over the past 25 years the average mutual fund earned an average annual return of 7.8%. Do we, as investors, get to keep 100% of that 7.8% growth? In short, NO WE DON'T. In addition to the fees that we pay mutual fund managers, there's another cost that we investors incur: the cost of EMOTIONS. The information shared below is taken out of Chapter 7 of Jack Bogle's book: "The Little Book of Common Sense Investing."

When Mutual fund managers report their earnings for the year they use something known as Time-Weighted returns. Time-weighted returns is a measure used by Fund Managers to show that the growth of their fund was due to the change in asset values of each share that they hold, adjusted to reflect the reinvestment of all income from dividends and any capital gain distributions. Wait, I didn't get that. It's basically managers saying to the public, "Hey! Our fund grew because we reinvested dividends and the value of each share of our assets appreciated over time because they're really good assets and people are buying them!! Aren't we awesome at picking the right assets!?!"

Time-weighted returns, however do not account for capital flows into and out of the fund (Capital flows AKA investors making deposits and withdrawals). This is an important point to understand, because capital flows affect the returns earned by investors.

Over the 25 year period (1991-2016), using the Time-weighted measure, the average mutual fund earned a return of 7.8%--1.3% percentage points less that the 9.1% return of the S&P 500. Time-weighted returns do not tell us what the investors took home. In order to figure that out we have to use another measure known as Dollar-weighted returns.

When we use this measure, the returns earned by investors turn out to be significantly lower. Dollar-weighted returns DO account for capital flows(Deposits and Withdrawals) into and out of the fund. A helpful hint to remember: The period following good fund performance, people get emotionally enticed and want to jump in on the band wagon, so they invest more money into the fund and make the fund look more valuable(Capital flows in). Periods after bad performance, people get discouraged and take their money out (Capital flows out).

When we account for the capital flows, the returns earned by the investors are in fact lower. Instead of the 7.8% return reported by the fund managers, Investors earned 6.3%--a whopping 1.5% less per year than that of the fund. So, while the S&P 500 earned an annual return of 9.1%, the mutual fund earned 7.8%, but the mutual fund investor only walked away with 6.3% a year.

I would like to note that, index fund investors also got enticed by the heady optimism of the market and were therefore affected by the adverse impact of capital flows, but by far less. Index fund investors, during this same 25 year period earned a return of 8.9%, 0.2% short of the Index fund itself.

The 1.5% points lost by mutual fund investors compounded over the 25 year period had some seriously adverse effects on investor's profits, but the dual penalties of bad timing and poor selection of mutual funds, made it hurt even more.

Exhibit 7.1 Below, taken from Jack Bogle's book: "The Little Book of Common Sense Investing," compares a $10k investment made in an S&P 500 Index fund and a Mutual Fund during a 25 year period (1991-2016). The graph below may be a little complicated to look at, but I'll break it down as simply as I can, because the conclusion we draw from this is quite important to understand.

The two bars on the left side (Circled in green) of the graph compares the growth of the S&P 500 with an Index fund tracking the S&P 500. The S&P 500 would have turned our initial $10k investment into $79,200 (Annual Rate of return of 9.1%). The S&P 500 Index tracking fund grew our $10k investment to $77,000 of which the investor got to keep $73,100 due to the low fees inherent to index funds (if you look at the legend on the right side, the lighter grey bar signifies the investor's return). After an inflation rate (which I will explain in a future blog post) of 2.7%, the real return that investors gained was 6.2% or $34,500.

If we compare that to the Mutual Fund (circled in red), out of the $79,200 that was available, the mutual fund returned a profit of $55,500--72% of what was available. After fees, the investor took home a profit of $36,100--50% of what the index fund investor took home. After factoring in a 2.7% inflation rate, the REAL return for the mutual fund investor was only $14,400!!! For 25 years of investing and putting up 100% of the money and taking 100% of the risk, that's nothing!

Conclusion: 1) long term returns earned by mutual funds lag the stock market by a substantial amount largely due to their costs and 2) the returns earned by the mutual fund investors lag the market by more than double. Why? It's because most investors have very little control over their emotions, which results in poor timing and poor fund selection. But wait, I thought we, as layman investors, don't have to time the market? Yes that's true as long as you have control over your emotions. As long as you don't fold when the next recession or depression hits and you don't get overconfident when things are going really well. If you maintain your emotions during these two important points in the business cycle then you won't fall for the advertising and promotions of mutual funds and try to beat the market.

BUT if you are trying to time the market AND trying pick the right fund, then you will pay a severe penalty on top of the fees you are already paying the mutual fund. Remember, you as a layman investor don't have time to time the market or pick the right funds. You've got other work to do!!

THIS IS WHY INDEX FUNDS ARE SO GREAT! We not only keep our fees extremely low, but we also cut out the emotions of timing the game and picking the right stocks or funds. We simply keep investing money into an S&P 500 index tracking fund on our own (If you need suggestions for how to get started in investing in index funds, check out the blog post: "Index Funds") and hold it for the rest of our days. And then periodically if we need income we can cash out what we need, but that's only after our nest egg reaches a considerable size.

The emotions of the game are key in becoming a successful investor and index funds allow the layman investor to keep them in check. Once you buy, you keep. A helpful tip from Jack Bogle to remember when investing: "When counterproductive investor emotions are magnified by counterproductive fund industry promotions, little good is apt to result." Mutual funds will promote the hell out of themselves and try to entice you emotionally to invest your money with them. But remember you don't get to keep 100% of the returns they earn because of the fees they charge you. They will, a majority of the time, lag the market return and as a result, you will lag the market return by double. That's a loser's game.

"The winning formula for success in investing is owning the entire stock market through an index fund, and then doing nothing. Just stay the course," Jack Bogle.

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