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According to the 2018 DALBAR study, the average equity fund investor sucks at investing! That’s not precisely what DALBAR stated, but that’s the conclusion I made after reading their report.
The DALBAR report is a comprehensive study that spans over the past 20 years with the most current report studying investor behavior from 1997-2017. If you take the time to dive into the study, you can see some interesting information.
As stated in the study, the average equity fund investor averaged 5.29%, and the S&P 500 averaged 7.20% over the past 20 years. This means the average equity fund investor trailed the S&P 500 by 1.91% per year.
Maybe 1.91% doesn’t appear to be much, but over 20, 30 or 40 years; that can determine the reason why you retire comfortably or why you delay retirement 10 years.
Let’s look at this example:
Let’s assume two people invest $500 a month for 30 years. Investor A invests in the S&P 500 and gets an average return of 7.20%. Investor B is the average equity fund investor and earns 5.29% a year.
Over the course of 30 years, each person invests a total of $180,000.
However, each investor has a totally different outcome. After 30 years, below are their total portfolios:
Investor A: $638,420
Investor B: $441,108
That’s a difference of $197,312 or about $8,000-$10,000 a year in retirement income!
Why does the average equity fund investor perform so poorly?
There are numerous reasons why investors trail the index. Some of these reasons include investors:
- Get scared when the markets go down and pull out
- Don’t reap the rewards of market gains because they watch from the sidelines
- Have poor market timing
- Don’t know what they are doing
- Pay too much in fees in their mutual fund accounts
- Have no diversification
- Place all of their money in an equity index fund
- Too emotionally involved
However, I don’t want to focus on why the average equity fund investor trails the S&P 500 index; I want to focus on how you can beat the returns of the average equity fund investor.
4 Rules to Follow to Beat the Average Equity Fund Investor
1) Own Index Funds NOT Mutual Funds
Warren Buffet said, “A low-cost index fund is the most sensible equity investment for the great majority of investors. My mentor, Ben Graham, took this position many years ago, and everything I have seen since convinces me of its truth.”
When one of the best investors of all-time makes this statement, we should probably listen.
Let’s start with the difference between the two types of investments.
Mutual funds, for the most part, are actively managed funds; this means the company hires managers to buy and sell stocks in hopes of beating the indexes.
Unfortunately, these managers often do not beat the indexes. SPIVA (S&P Indices Versus Active), states that 91.91% of large-cap equity fund managers have underperformed the S&P 500 for the past five years.
On the other hand, an index fund is a passively managed portfolio. Instead of hiring expensive fund managers, they create portfolios to generate returns equal to the equivalent index.
If a company has an S&P 500 fund, they try to own the 500 stocks in the index with the same proportions as they exist in the market.
The benefits of owning an index fund include:
- Lower fees
- Better/same returns than most actively managed mutual funds
- Typically, no commissions to buy one
- More tax efficient than mutual funds
If you don’t believe me, then check out MomandDadMoney.com article, “Why All My Investments are with Vanguard.”
2. Keep Expenses Low
Forbes stated that the all-in cost for the average mutual fund is 3.17% a year.
These are high fees for any money manager to overcome. Just to beat the S&P 500 index over the past two decades, managers would have had to earn a return of 10.37%.
Additionally, the fees impact a portfolio negatively. If you were to invest in a mutual fund that beat the S&P by one percentage point before expenses, you would still end up losing.
After 30 years, you would have just 65% of what an index fund investor had in their portfolio.
Senator Peter Fitzgerald once said, “The mutual fund industry is now the world’s largest skimming operation, a $7 trillion trough from which fund managers, brokers, and other insiders are steadily siphoning off an excessive slice of the nation’s household, college and retirement savings.”
The group at Making Momentum details how investment fees can affect your portfolio and dedicated an entire post to the topic. This is a great read if you want to learn how they really impact your portfolio.
3. Stay Invested
Staying invested for the long-haul, 20 or 30 years, is essential to getting the most out of your returns.
There are two reasons to make sure you stay invested; 1) Compound interest 2) It’s impossible to time the market.
Albert Einstein brilliantly said, “compound interest is the eighth wonder of the world. He who understands it earns it. He who doesn’t pay it.”
The simple definition of compound interest is when when your interest earns interest. To completely understand compound interest, check out this excellent article at SmartonMoney.com.
The second reason to stay invested (even through market downturns) is that you can’t time the market.
As Daniel Kahneman said, “the average investor’s return is significantly lower than market indices due primarily to market timing.”
What usually happens is investors take their money out of the market after it drops because they can’t handle the loss. So they end up with a 20% loss. Then they decide to invest back into the market after the market has recaptured its losses.
When I was an advisor, I met with hundreds of people who pulled their money out of the market when it hit rock bottom in 2008. Then they waited until 2011 or later to get back into the market.
We don’t know when the market will go up or down; so make sure you stay invested.
4. Diversify/Asset Allocation
You have undoubtedly heard the phrase, don’t put all of your eggs in one basket; this is an important concept to understand for every investor.
We don’t want all of our money in one stock because if that company fails (Enron), then we lose everything. That’s exactly how I lost nearly $40,000 at the age of 28 (lesson learned).
Diversification is ensuring all of your money is not just in one place (i.e., Apple Stock). Asset allocation is investing in different asset classes (i.e., big companies, small companies, value companies, growth companies, international, etc.).
Both of these concepts are important because it helps improve portfolios over the long-term.
MoneyGlare.com has an excellent article about the Importance of Investment Diversification.
A solid portfolio should be diversified with asset classes from:
- Large-cap stocks (growth & value)
- Small-cap stocks
- Emerging market stocks
- Bonds (short and long term)
- International bonds
- Real Estate
Investing doesn’t have to be scary or complicated. You can create a portfolio that beats the majority of the average equity fund investors by following the four simple rules above.
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