Investors Are Missing the Bull Market

Suppose they gave a bull market and nobody came? That pretty much sums up the response of individual investors to the past year’s run-up in share prices. Left stunned and frightened by the preceding collapse of share prices, individual investors have lightened up on stock funds and shoveled money into bond funds.

Those who exited stocks have missed a breathtaking rally. Standard & Poor’s 500-stock index returned 50% over the past 12 months through March 18. During the same period, the MSCI EAFE index of developed-market foreign stocks galloped 61%, the Russell 2000 index of small companies soared 66%, and the MSCI Emerging Markets index surged 89%. It doesn’t get much better than that.

But fear of more losses has been a more potent consideration for most investors. The Leuthold Group, a Minneapolis-based research firm, computes that from the start of 2009 through March 10, 2010, investors, in aggregate, sold $6 billion in stock funds and purchased $446 billion in bond funds. Only in the past few weeks, as major averages have continued to rise, have stock funds finally begun to see net inflows (meaning more cash has been coming in than going out).

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To be sure, many investors have simply stood still during the bull market, which celebrated its first birthday on March 9. A total of $4.8 trillion is invested in stock mutual funds. But, as a group, investors have been selling, not buying, during one of the most powerful rallies in history.

What’s more, investors rushing into bond funds may well hit a buzz saw. By keeping short-term rates near zero and pumping money into the nation’s moribund economy, the Federal Reserve may be planting the seeds of a significant jump in inflation at some point in the future. When that happens, bond yields are likely to rise, pushing down bond prices.

When it comes to making decisions about mutual funds, bad choices are standard operating procedure. Whether due to poor timing, poor fund selection or both, the average investor tends to earn a good deal less in the stock market than the reported returns of funds would indicate.

How can that be? An example will help. Suppose you have a fund with $100 million in assets. Over a 12-month period, it gains 40%, so its asset base climbs to $140 million. The fund garners a ton of positive media attention, investors rush to buy, and assets climb to $500 million. But in the ensuing year, the fund loses 28.6%. The fund itself has broken even at the end of the two years. But far more investors have lost money than have made money.

That, in a nutshell, is what happens in the real world. Morningstar figures that over the ten-year period through the end of 2009, the average mutual fund returned an annualized 3.2%. But the average dollar invested in mutual funds earned an annualized 1.7%. U.S. stock funds returned an annualized 1.6% over this period. But investors, on average, earned an annualized 0.2% -- an average of 1.4 percentage points per year less. Foreign stock funds returned an annualized 3.2%; investors earned an annualized 2.6%, or 0.6 point per year less.

The bottom line: Investors don’t do as well as mutual funds by roughly 0.5 to 1 percentage point per year. And, as we know, over long periods two-thirds of actively managed mutual funds fail to match the returns of the index they’re trying to beat. Combine the two factors, and investors are earning a whole lot less than what the market offers (see Why Your Results Stink).

How to improve your returns

Do you see yourself in this picture? We all make investing mistakes. Even Warren Buffett, in his annual reports, spends a lot of time discussing the mistakes he made over the previous year. But, over time, he has made far more smart moves than dumb ones.

How can you invest more like Buffett and less like the average investor? He gives one important clue: Analyze your mistakes. Try to figure out what went wrong and why so that you can, perhaps, avoid making the same error again. (See Learn From the World's Great Investors.)

A good deal of investing is common sense. Keep your costs low, invest small amounts regularly, shun investments you don’t understand. For more ideas, see our Investor Psychology special report and 5 Lessons From the Crash -- and Recovery. Unless you plan to spend serious time on investing, stick to a portfolio of index funds, such as the one provided in Don't Abandon Stocks.

Perhaps most important, don’t try to time the market’s short-term moves. No one can, as the numbers in this article so sadly illustrate.

Steven T. Goldberg is an investment adviser in the Washington, D.C., area.