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Originally published March 9, 2013 at 8:01 PM | Page modified March 10, 2013 at 11:10 AM

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Chuck Jaffe: Investors need to learn to hang on

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Your Funds

Investors complain a lot about the performance of their mutual funds, but they’d be a lot happier and do better financially if they simply got the same results as those funds earn.

Instead, a new study from investment researcher Morningstar shows that investors habitually get the worst from their funds, earning returns that are inferior to the investment vehicles they are buying.

You don’t have to settle for that.

To see why, consider the latest research from Russel Kinnel, Morningstar’s director of fund research, who compared a straight average of fund returns to asset- or dollar-weighted average investor returns.

Dollar-weighted returns are designed to show a fund’s results based on when money moves in or out; they show if investors are chasing performance, buying funds only after a big run-up or losing faith and selling before a rebound.

Kinnel found that over the decade ended in 2012, the average fund returned 7.05 percent annually, but the average investor netted 6.1 percent.

In certain asset classes, the disparity is much greater; Kinnel found that the average international equity fund earned almost 10 percent, but that the average investor in those funds netted under 7 percent. The discrepancy was also large in municipal-bond funds, surprising because it’s not an asset class where shareholders go performance-chasing.

Indeed, with munis being one of the least-volatile asset classes, the category is a petri dish for the problem.

Kinnel surmises that investors actually did the right thing and threw money into the category after its one year in the red (2008), and enjoyed double-digit gains in 2009.

But as worries about government defaults captured the headlines, investors bailed out to avoid the potential storm and missed big up years in both 2011 and ’12.

Giving into fear or greed is the root cause here, but investors may not recognize that their behavior contributes to the shortfall.

“Mutual funds are long-term investments and the way to get a superior return is to hold it for a long time,” said Kinnel.

“It used to be that people made decisions based on the fund’s returns over the last few years. Now it seems to be that they make decisions based on the 24-hour news cycle and what they just heard. Either way, they’re making bad decisions.”

Here’s how that plays out:

The typical investor buys funds only after a strong run of good results, thus they are buying high. Their money did not get that positive performance stretch, however; they only get what happens next.

If the investor sells when the fund falters, they not only lock in a loss or poor results, but they go a bit insane, repeating the process again — buying another fund that has been hot — but expecting different results.

Thus investors keep getting poor performance out of what should be good funds.

Here’s how to get performance that’s close to what the fund provides: Buy in, ride along, reinvest dividends and distributions, and make additional deposits either regularly or when the fund feels cheap or undervalued, rather than when it has made the account statement look fat.

“Macro timing is bad for people because they fool themselves into thinking they can outsmart the market,” Kinnel said. “They hear some news or see some hot numbers and they don’t realize that in jumping on this bandwagon, what they are saying is ‘There’s a lot more good news coming, even though I don’t know anything more than anyone else about this.’ ”

It’s important to recognize that lackluster dollar-weighted returns are caused by the individual investor, not the fund, and that they happen to people who own good funds.

“The one way you can wreck a diversified portfolio of solid, low-cost mutual funds is by doing a lot of market calls,” Kinnel said.

“You could be moving from a great emerging-market bond fund into a U.S. equity fund the next; both could be good funds, but if your timing is off, all you are going to get is the worst of them both, instead of holding on and letting the fund do the work and getting the best of them both.”

Avoiding the problem involves striking an appropriate balance between fear and greed, and not acting on either.

In fact, the best way to come ensure performance that is close to what the fund delivers is to rebalance a portfolio.

In rebalancing, investors prune their leaders and spice up their laggards to put their portfolio back to its target asset allocation.

In a simple example, say an investor is trying to have a 50-50 mix of stocks and bonds, and a market run-up makes it so the portfolio is 55 percent stocks; rebalancing would require moving

5 percent of assets out of stocks and into bonds to re-establish the 50-50 split.

That’s one of the few times when investors are selling high and buying low.

Behavioral finance experts note that investors don’t need to ignore human nature, but rather have to understand it.

Donald MacGregor of MacGregor Bates, a Eugene, Ore., firm that does judgment- and decision-making research, noted that investors who take recommendations “need to recognize that, at least when they start [building a portfolio], they will gravitate toward winners. ... That will be fine, so long as they own those winners long enough to get through the times when they’re not doing so well, because the winner you buy today is not going to go up all the time in all conditions.”

Added Morningstar’s Kinnel: “I don’t think you can ask investors to buy bad funds, thinking that they will go up and the good ones will go down.

“What you can do is recognize that if you buy a fund because you think it’s good, you have to be willing to stick with it. It didn’t build that good track record by going straight up, so you can’t expect it to go straight up from when you buy it.”

Chuck Jaffe is senior columnist for MarketWatch. He can be reached at cjaffe@marketwatch.com or at P.O. Box 70, Cohasset, MA 02025-0070.

Copyright, 2013, MarketWatch

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