Have a Plan to Boost Your Investment Returns

When it comes to investment returns, it seems everyone wants to pick the perfect portfolio, maximize gains, and beat the market. But what if the strategies typically employed to chase maximum returns are actually backfiring on the average mutual fund investor?

According to a 2015 report by independent market research firm DALBAR, the period from 1995-2014 saw the average investor lag 4.66% behind the annualized returns of the S&P 500, a common group of stocks used to summarize U.S. stock market returns. In the chart below you can see that this underperformance is costly, leading to a drastically lower account balance over the long term.

The wide difference in returns can be explained primarily by two facts: the general underperformance of actively managed mutual funds compared to the stock market; and irrational investor behavior when markets become volatile. The three “less-is-more” strategies outlined below are designed to help you separate yourself from the average investor and increase your likelihood of better returns.

1. Opt for Indexing

Inspired by research that showed that most mutual funds do not produce better returns than the benchmarks they track, a new investment vehicle was born: index funds. Unlike “active” mutual funds that try to pick individual stocks, these funds simply track an index, such as the 30 stocks in the Dow Jones Industrial Average or the 500 companies in the S&P 500.

Since Vanguard launched the first index fund in 1976, this type of “passive” investing has produced steady, improved returns for the average investor (compared to those with money in active funds) -- in fact, one of the most popular index funds that tracks the S&P 500 has outperformed 80% of active mutual funds over the past five years, ballooning to over $200 billion in assets.

Also, because index funds aren’t actively traded, they tend to feature lower fees and expenses, leaving more money in investors' pockets. By opting for indexing instead of trying to pick the perfect mutual fund, you’ve simplified your investment strategy, diversified your portfolio, cut the costs eroding your portfolio, and in all likelihood improved your long-term returns. Nice work!

2. Buy and Hold Your Funds

You can also help improve the outlook on your investment returns by committing to buy and hang on to your funds instead of trying to time the market (i.e., jumping into funds when you believe the market is going up and selling out of funds when you think losses are on the horizon).

DALBAR’s research showed that “mutual fund investors who hold onto their investments have been more successful than those who try to time the market.” Their study of investor behavior kept track of when people took money out of mutual funds, and when they poured investments in. They found that the largest outflows of mutual funds (times of selling) occurred in times of panic when the stock market was dropping, and the largest inflows (times of buying) happened in the euphoric period in the middle or top of a bull market when stocks are rising.

Their conclusion: investors sold low and bought high. Talk about bad timing! Market timers can easily fall prey to emotions that lead to costly mistakes. Follow DALBAR’s advice and correct for this by planning to buy your investments and hold them for the long term, adding to them at regular intervals in order to benefit from dollar-cost averaging.

3. Put an Emergency Plan in Place

Growing up in school, kids regularly run through fire drills to prepare for disaster before it occurs. When the markets get shaky, a similar plan is necessary so you can stick to your commitment to buy and hold.

It’s one thing to say, “I’m a buy-and-hold investor,” and another altogether to follow through on that strategy when stocks are in a free-fall, your net worth is plummeting, and the pit in your stomach has become a black hole.

Don’t sell in a panic. Cover your eyes when the news starts covering the “collapse.” Your emergency plan should be simple: stick to the plan you had before the emergency. Keep calm and carry on. The market has fallen before, and history has generally shown that the best thing to do in the wake of a drop in prices is to hold on tight.

As financial writer Dave Ramsey says, “The only people who get hurt on a roller coaster are those who jump off.” Having a plan in place will help you stay the course when you want to react.

Source: DALBAR’s 21st Annual Quantitative Analysis of Investor Behavior, 2015 Advisor edition.