How Not to Invest in Mutual Funds

Investors are notoriously poor market timers. They pour into what's been hot recently, only to jump out as it inevitably cools, again using their rear view mirror to guide their next decision. The result is a wide gap between the returns earned by mutual funds and the returns earned by the typical mutual fund investor.

Many outlets -- including CBS MoneyWatch, Morningstar, Dalbar, and a host of others -- have reported the poor returns that result from this behavior. And while I grant that the figures themselves are often startling (even depressing), I thought it might be interesting to focus on the decisions that produce that performance.

To do so, I took a look at investor assets over the past ten years in four asset classes: domestic stocks, international stocks, bonds, and money markets. Using total assets in each of these categories at the end of each year gives us a rough approximation of the average fund investor's asset allocation throughout the decade, and, importantly, how that allocation shifted during that period.

The results are presented in the chart to below. As you can see, the typical fund investor's allocation to domestic stock funds maxed out in 1999 -- just at the market's peak -- and reached its low at the end of 2008, just before the market reached its recent bottom. Likewise, allocations to money markets peaked at stock market lows, in 2002 and 2008. We all know, of course, that buying high and selling low is a terrible way to make money. Yet these numbers demonstrate just how hard it is avoid doing so when our emotions are telling us to load up on stocks in the good times, and to bail out when the stock market hits the skids.

You can also see the rising allocation to international stocks, from a low of six percent in 2002 to a high of 17 percent in 2007. It's hardly shocking to note that those years bracket a five-year run of strong returns in international stocks (including emerging markets), which came to an abrupt end in 2008. Once again, mutual fund investors were light at the beginning of the bull run, and most bullish when the bear hit.

Next, I ran some numbers to see what an investor with these shifting allocations would have earned for the decade, using the Dow Jones Total Stock Market index (domestic stocks), MSCI EAFE index (international stocks), Barclay's U.S. Aggregate Total Bond Market index (bonds), and the 90-day Treasury Bill (money markets) to represent the annual returns of each asset class.

The result? Such a shifting asset allocation would have produced an annual return of 1.8 percent for the ten years ended 2009. At that rate, each $1 invested at the outset would have grown to $1.20 by the end of the period.

To gauge the effectiveness of fund investors' decision-making, we need to measure that return against a reasonable alternative. For such, I used an allocation of 40 percent domestic stocks, 20 percent international stocks, and 40 percent bonds -- representing the sort of middle-of-the-road portfolio that might be recommended for a typical investor.

Such an allocation, rebalanced annually, would have earned 3.5 percent per year for the decade, growing each dollar to $1.40 by 2009.

Yes, it's far from the double-digit returns that investors of a decade ago had grown accustomed to, but it produced twice the growth offered by the rear view mirror style of asset shifting that fund investors in the aggregate used. (And don't overlook the fact that the investors' return, in this case, is likely overstated by the use of index returns for the period, ignoring the fact that the funds actually used by these investors inevitably earned returns much below that standard.)

It's easy, in the abstract, to convince yourself that your portfolio matches your goals and your risk tolerance. But as the experience of mutual fund investors in aggregate over the past decade demonstrates, it's much easier to play Monday morning quarterback with your portfolio -- becoming captivated with a market sector after it has produced impressive results, only to throw in the towel at the first sign of trouble. Decisions made in relative haste often lack conviction, and are easily abandoned.

So the next time you find yourself drawn to a particular investment style or sector, do a reality check, and ask yourself if your newfound beliefs are strong enough to withstand a 40 or 50 percent decline in the years to come. A little brutal honesty might go a long way toward protecting your portfolio from yourself.