The Dangers Of Chasing Returns

It probably comes as no surprise that investors typically don’t get the returns that are advertised by mutual funds.  Mutual fund returns assume that the investor puts their money in at the beginning of the time period and holds the investment until the end.  Investors, however, typically move their money in and out based on need or, in a lot of cases, how the fund is performing.

Investors can be their own worst enemies when emotions get in the way.  A large swath of investors declares their strategy to be to chase whatever is producing the hottest returns at the time.  What they’re really doing is jumping on the bandwagon after most of the returns have already been realized only to find themselves hanging on when things start heading south again.

There was a stat that I saw published the other day.  It said that the S&P 500 is up about 93% since the market bottomed out in March 2009.  In that time, investors have pulled a net $22.8 billion out of stock mutual funds.  Is this type of behavior unusual?  Unfortunately not.

This is just the latest example of investors chasing returns.  The best example of this was during the tech bubble of about 10 years ago.  As the market continued its march almost directly upward and the NASDAQ passed 5000, mutual funds experienced a real boom.  Companies offering mutual funds opened the doors to let these folks in and even offered new funds specializing in technology and internet stocks just to meet the insatiable investor demand.  Money was pouring in as regular investors wanted their piece of the pie.

The only problem was that we were just a few short months away from everything turning around.  These regular investors, many of whom had invested in the stock market for the first time, jumped on just in time to watch it all start heading south.  The problem is that a lot of these investors never bothered to take a look at what they were buying or how it fit into their portfolio.  They simply saw advertisements of 100%+ returns and they wanted in.  Mutual fund companies were guilty in this too.  They spent more time figuring out ways to get money in the door than to really think about what the longer-term implications of their actions were.

This characterization doesn’t cover everybody obviously.  There are some who are pulling their money out to cover bills and daily expenses but there are undoubtedly a large number of people that are performance chasing.  There’s a contrarian investing theory out there that says you should follow the mutual fund inflows and outflows and then do the exact opposite.  It sounds a little unusual but historically speaking it hasn’t been that far from the truth.

The lesson here is to buy and sell based on the merits of your overall portfolio and not just because of some historical performance number.  Some estimates say that while the stock market has returned 9-10% per year over the long term, the typical investor has only seen a return of around 3% per year due to their attempts at market timing and performance chasing.  Long-term investing is designed so that you can ride out the short-term fluctuations of the markets and your investments and reap the long-term benefits.  If you can maintain discipline, you can be the one touting those big numbers in your portfolio.

Photo credit: Andrew Pescod

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3. IRS Gives April 16 Storm Victims Two Extra Days to File Their Tax Returns
4. Dangers of Frugality
5. Is Small-Cap Making a Comeback?

Original Post on The Sun’s Financial Diary

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The Dangers Of Chasing Returns

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