We believe market timing is an important tool to help investors achieve the returns they need while reducing their exposure to unpleasant surprises. But that is true only for systematic market timing. Unfortunately, many investors use timing not as a discipline, as we do, but as an informal and unpredictable expression of their own emotions, primarily greed and fear.

Here we look at the investment returns of mutual funds and show why many investors never get the returns quoted in advertisements and magazine articles. Thanks to government regulations, the return figures that funds are allowed to quote are now standardized throughout the industry. Yet you will see that those figures don't necessarily represent the real returns that real people get in the real world.

Confused already? Stick with it a minute or two, because this isn't hard and it's worth your time. To understand this, you'll have to know the difference between a time-weighted return and a dollar-weighted return.

Time-weighted returns are the figures you see in ads and articles in newspapers, magazines and newsletters like this one. These figures represent the return an investor would have achieved with a single deposit left to accumulate and compound over some period of time. One traditional use of time-weighted returns shows what happened to $10,000 invested in a fund on its first day of existence or other starting point, then left to compound for however many years are being measured. This is an excellent way to compare managers or compare funds, because for any specific time period you are comparing apples against apples, oranges against oranges.

But real life is seldom that simple. How many people do you know who put $10,000 into a fund on the first day of a period and then simply left it there to compound? How many people invest once, on the first business day of January, hold their money until the end of the year and then sell on the last business day of December? Well, I can't think of anybody who does that either! Yet the mutual fund industry, at the government's direction, keeps score that way, even though those returns don't apply to many real investors.

This brings us to the concept of the dollar-weighted return, sometimes called an internal rate of return. In simple terms, this measures the gain or loss of actual money invested in a fund for an actual time period. This is the return that you, as an investor, get if you buy into a fund on April 29 one year and sell on July 8 three years later. This figure also calculates your real annualized return if you add more money after your initial investment. To summarize, the dollar-weighted return takes all transactions into account, along with the exact date of each one, and it follows actual amounts of money that go into and out of a fund.

You can see that a dollar-weighted return isn't very good for comparing one fund or one manager with another. But it's very good at describing the actual experience of real investors. And this calculation can show returns not just for individuals but for large groups of investors. For instance, it's possible to trace all the money that went into and out of a fund for a given period of time, then figure out a dollar-weighted return to show what the fund's investors actually achieved. Morningstar Mutual Funds did exactly that in a study of time-weighted returns in mutual funds over the six years from the end of 1988 through the end of 1994. The study concluded that the average dollar invested in 199 growth funds experienced only a small fraction of the growth implied in the official time-weighted returns of those funds. The reason: real investors did not adopt a buy-and-hold strategy. Instead, they moved money into and out of the funds in an informal (but not random) system of market timing. Morningstar found that large amounts of money flowed into those funds at or near the peaks of the market. And large amounts flowed out near the bottoms of markets, and did not return to the funds until after the market had already recovered. This is exactly the opposite of effective market timing, yet it is what most investors did. And their results suffered accordingly.

Morningstar's study, of course, could not be based on individual account records. It was based on estimated net cash inflows and outflows. While the results cannot show any particular investor's returns, they do show the overall results of the investors in the fund. It reports those overall results as if the fund had a single investor.

THE SHOCKING RESULTS

For the period from December 31, 1988 through December 31, 1994 the S&P 500 Stock Index had an average time-weighted return of 12.22 percent. The corresponding return for the 199 funds studied by Morningstar was 12.01 percent. But the dollar-weighted return of those funds in that period was only 2.02 percent. In other words, over this six-year period, the average dollar invested in these funds achieved a return of about one-sixth of the growth in the market and one-sixth of the growth in the funds themselves, as conventionally measured. That is because investors had their money in the funds only part of the time and those investors chose the timing based on their own reactions to market conditions.

I quote from Morningstar, which said its study "may suggest the reason behind some of the negative perception of investing by the public. More importantly, it shows that people are getting in too late (and maybe even getting out too early). This may also indicate that people are unwilling to make the tough calls to invest on the way down (and perhaps divest on the way up). It indicates that the reverse is more of the norm. That is, the investing public interprets a market's direction as continuing. Therefore, they invest when the market has shown a definite upswing (which may be too late) and they pull out in a definite downswing (which may also be too late). Therefore, the return that the average investor realizes has more to do with investor behavior than with investment results."

Undoubtedly many investors suffered from this anomaly in one form or another this past winter. Last year was a dreary, discouraging one for most investors in stocks and bonds. Then somehow, as if by magic, when most commentators and analysts were predicting very modest improvement at best, 1995 came in like a tiger, producing some old-time, heart-pounding investment returns in most sectors (except international) in the first quarter of this year. I believe many investors who should have been putting money into the market in the last quarter of 1994 were instead moving to the sidelines, discouraged with the poor showing they saw last year. In retrospect, they made the exact wrong moves, basing their timing decisions on what we call the "I Can't Stand It Any More" market timing system. It's one of the most widely used systems anywhere, as Morningstar's study shows. But unfortunately for those investors, this system produces awful results. And this same system is probably leading some people back into the markets this month, and they may or may not be glad they got in now. But one thing is certain about those investors: They must pay the prices in effect after this year's first quarter, missing out completely on the returns that now attract them into the market.

Morningstar did this equity fund study and a similar five-year study of U.S. bond funds for FundMinder (15233 Ventura Blvd., Sherman Oaks, CA 91403). The bond study tracked 275 taxable bond funds with intermediate and long-term maturities. Morningstar found that the average dollar invested in those funds appreciated significantly less than the time-weighted returns of the funds. While the funds' five-year annualized returns averaged 7.94 percent, the average dollar-weighted results of investors in those funds was only 1.05 percent. Morningstar said this bond fund study led it to the same basic conclusions: many people get into the market too late, they often get out too early, and their returns have more to do with their own behavior than with the markets.

These studies quantify something I have suspected for years. Many, perhaps most, investment advisors and financial planners advocate buying-and-holding instead of market timing. Most investors probably think they are following buy-and-hold strategies, but in fact, big flows of money move into and out of the domestic stock and bond markets with rough correlation to market peaks and dips-and those flows are usually made in the wrong direction. This illustrates on a massive scale, the perils of do-it-yourself market timing. No wonder our critics believe market timing is a loser's game. If you follow your gut instead of a system, you are almost certainly setting yourself up for disappointment.

Morningstar's studies covered only domestic mutual funds. But many people moved into international stock funds in a big way last year after that sector's large gains in 1993. Starting late last year, and accelerating rapidly this year with the fall of the Mexican peso, international stock funds moved away from star status and into negative territory.

Partly because of this do-it-yourself market timing, 1993 saw emerging market funds with large returns and little money. Then in 1994, the same fund category had lots of money and lousy returns. Many of the people who got into those funds last year were first-time investors in the overseas arena. They got burned. And many probably will never invest internationally again, which is a shame because this sector has great promise for true market timers and true buy-and-hold investors alike.

There's a lesson here for investors, and this is what I think it is: If you have a lump sum of money to invest and you don't follow a timing discipline, do your asset allocation first (it produces most of your returns anyway, as we have discussed before) and dollar-cost-average your way into the markets over a period of years. This is not a perfect way to invest but it will beat the pants off the do-it-yourself timing results that Morningstar found.

Remember this conclusion from Morningstar: "The return that the average investor realizes has more to do with investor behavior than with investment results." And that phrase "investor behavior" means do-it-yourself market timing. Our market timing systems are designed to avoid precisely that trap. And we believe such ill-advised behavior is becoming more prevalent as more segments of the media and more brokerage houses publish, emphasize and focus on short-term investment performance. The effect is magnified by new distribution channels for mutual funds such as Charles Schwab, which is turning itself into the largest mutual fund family of all by allowing investors to switch in and out of funds, regardless of the fund sponsor (Janus, Fidelity, Founders etc.), with a single phone call and no transaction fee. Fund sponsors like Janus, Invesco and Berger are becoming major advertisers on mainstream television as they recognize the growing importance of these new distribution channels that did not exist five years ago.

Improved distribution channels offer many valuable benefits. But when working people are encouraged to use the latest quarter's results to switch their retirement money from fund to fund within a 401(k) plan, I just don't believe those people are being well served by this industry. The Morningstar study reveals a symptom of an illness that's brought on by two psychological forces: greed and fear. Investors should be encouraged to reduce the importance of those two forces. Unfortunately, large parts of the industry and the media are in effect encouraging just the opposite.

 

 

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