Removing Obstacles to Better Investing
The Dow Jones industrial average generated average returns of 18.2% a year in the 1990s. The Nasdaq composite index surged 24.5% a year. The average U.S. stock mutual fund returned 15.4% a year.
And your personal portfolio return was . . . what?
If you don’t know, you’re not alone. Most individual investors would be hard-pressed to say whether their portfolio gains even came close to the market averages in the ‘90s.
And therein lies one of the greatest challenges for investors who want to speed up their wealth generation in the new decade: It might be easier to decide what you need to do to improve your future returns if you knew how short you fell in the past, and why.
In other words, it would help if you knew what you were doing wrong.
For most people, it’s almost certain that their own bull markets haven’t been nearly as good as the bull market they keep reading about.
Brad Barber and Terrance Odean, professors at UC Davis Graduate School of Management, recently studied the stock investments of 66,465 households between 1991 and 1996. They found that while the Standard & Poor’s 500-stock index gained an average of 17.9% a year during that period, the average household earned an annualized return of 16.4%.
Worse, households that tried to time the market by trading in and out of stocks frequently did considerably worse: They averaged just 11.4% a year.
For the decade overall, the S&P; 500 rose more than fourfold. But chances are the average investor’s portfolio tripled, at best, based on how the typical investor allocates his or her retirement assets.
To be fair, not all of us try to outpace the S&P; 500 or some other market benchmark. Many people don’t want to take that kind of risk.
For example, like most retired investors, Jim and Cathy Bradley don’t want to be fully invested in the stock market. Rather, the West Covina couple keep slightly more than half of their investment portfolio in bank certificates of deposit. That provides ballast for their retirement portfolio in a volatile stock market.
Plus, says Jim, 60, by structuring their portfolio this way, “We do not have to sell our [stock] mutual funds or our stocks for living expenses.”
But that 50%-plus stake in CDs kept the couple’s overall portfolio returns well below the S&P; 500. They estimate that their portfolio gained 10% to 15% a year between 1995 and 1998--less than half the annual S&P; returns of about 30%.
Could they, and millions of other investors, do better--without trying to go for broke in Internet stocks or significantly raising their risk levels?
The short answer is yes. By overcoming some of the classic obstacles to wealth generation, academics say you may be able to add five or six percentage points to your annual investment returns over time.
At the very least, understanding how these obstacles impede your portfolio returns can put you a step ahead in the race, experts say.
What follows is a look at four impediments to better returns, and how you can deal with them:
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Problem: Wrong Portfolio Mix
Effect on Returns: Like most investors, Richard Underhill, 55, holds a diversified portfolio of stock and bond funds and cash. “I’ve paid the price for not being all in equity funds in the last few years,” said the Los Angeles resident, whose portfolio mix currently stands at about 60% stocks, 30% bonds and 10% cash.
“Another price I have paid for being diversified for the last couple of years is owning value-style funds,” Underhill said. While the average small growth-stock fund soared 65.7% in 1999, small value-stock funds delivered paltry returns of just 4.8%, on average.
Clearly, Underhill wished he had invested more in technology and growth-stock funds last year. There is no single perfect portfolio mix, of course, and every shift involves raising or lowering your risk level somewhat.
But the start of the year is a good time to ask whether your mix is outdated for your stage in life and/or your market expectations.
What You Can Do: First, consider how your portfolio is split among growth stocks and value stocks. If you’re not sure in which category your mutual funds fall, use the Morningstar tables in this section to do a complete portfolio checkup.
The right mix of growth and value is an individual decision, but a classic mistake of conservative investors in recent years has been to underweight growth. If the economy continue to boom, growth stocks may continue to be the market leaders.
Likewise, strong global economic growth may keep foreign stocks hot; they rocketed in 1999, but may have much more catch-up to do.
Though the ‘90s overall weren’t kind to foreign issues--and many investors forgot about them--”We think the best funds over the next five years will come from some of the five-year lagging groups” of funds, said Michael Lipper, president of New York fund tracker Lipper Inc.
That group might include some of the Latin American, Asian and diversified emerging-markets funds that already made big moves in 1999.
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Problem: Bad Timing Decisions
Effect on Returns: You’ve heard it over and over again: Evidence suggests that most investors can’t time the market’s ups and downs. Better to stay invested for the long haul and tweak your portfolio’s mix from time to time--not shift wholesale among sectors.
Odean of UC Davis studied the stock-picking acumen of 10,000 investors, based on trades they made between January 1987 and December 1993. What he discovered was that on average, “The securities [investors] purchase actually underperform those they sell.” Take Ariel Linden, a health-care consultant in Encino. Two years ago, he put about $5,000 into a Latin American stock fund.
But just as he got in, the Asian economic crisis began to spread around the globe, and Latin markets fell. So in 1998, he sold and moved the money into Vontobel Eastern European Equity Fund. That was just in time for Russia’s currency devaluation, which sent Eastern European stocks reeling.
The 36-year-old quickly pulled out of that fund and moved into Fidelity Select Electronics. But by then, global financial worries had spread to Wall Street, and investors began fleeing high-risk investments. Fidelity Select Electronics fell nearly 25% between mid-August and mid-October of 1998. Linden sold--only to watch the fund rebound a stunning 264%.
What You Can Do: One way to avoid timing disasters: Commit to keeping the bulk of your stock portfolio in a market index fund, and let it be.
“Stop looking for the needle in the haystack, and just buy the haystack,” said John C. Bogle Sr., founder of Vanguard Group. In other words, instead of looking for that one sure-fire stock or stock fund, invest in the total stock market through a passively managed index fund, such as those that track the Wilshire 5,000 market index. In the long run, the index will be very hard to beat.
Bogle, considered the father of indexing, favors tracking the Wilshire 5,000 index rather than the S&P; 500. Roughly 20% of the Wilshire index is made up of small-company stocks, while the S&P; only holds blue-chip names.
As for individual sector bets, some investors will argue that it’s important to get out of a losing investment with minor losses rather than risk a complete collapse. They have a point.
So before making a sector bet, decide what kind of bet it is--one for the long haul to complement your core portfolio, or just a short-term speculation. If you set parameters in advance, you’re less likely to panic and make the wrong move in a sudden market storm.
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Problem: Taxes
Effect on Returns: A recent study by consulting firm KPMG found that taxes reduce a mutual fund’s overall return by 2.6 percentage points annually. That means if you invest in a fund in a taxable account, and it generated gains of 12% in a year, chances are your after-tax return was closer to 9.4% after you paid capital gains taxes or regular income taxes on the fund’s annual distributions.
For active traders, taxes can, of course, take as much as 39.6% of any net short-term trading profit (gains on securities held less than one year). And that’s just federal tax. Add California’s top tax rate of 9.3% on regular income such as short-term gains, and you’re surrendering nearly half of any net short-term profit to the tax authorities.
So while bad market-timing moves certainly hurt, even good timing moves may not yield the net profit you expected.
What You Can Do: It generally makes sense to invest as much as possible via tax-deferred retirement accounts: 401(k)s and IRAs.
If you don’t have that luxury, look for mutual funds that buy and hold stocks rather than trade rapidly. If neither you nor your fund managers do a lot of selling, you won’t realize much in the way of annual taxable capital gains.
Because index funds buy and hold stocks in a market benchmark, that’s a natural place to start. But be careful even there: Funds that track small-stock indexes such as the Russell 2,000 annually kick out stocks that get too large. As a result, the turnover rate of small-company index funds tends to be higher than in blue-chip index funds.
In addition to index funds, there is a growing list of so-called tax-managed funds, according to Morningstar (on the Web, go to https://news .morningstar.com/news/ms/ShortList/990409 short-1.html), plus a number of funds that are tax-efficient, but don’t market themselves as such. These funds minimize taxes in a variety of ways. For instance, if the fund wants to sell a winning stock, it might simultaneously sell a losing stock in the portfolio to match--and therefore offset--gains with losses.
As for investors in individual stocks, you have the ability to control your sell decisions and thus your capital gains. That’s why investors who have the wherewithal to build their own stock portfolios may have the best chance of maximizing long-term, after-tax returns.
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Problem: Fees and Trading Costs
Effect on Returns: The average domestic stock fund charges annual management expenses of 1.44%, which are deducted before total returns are calculated. Foreign funds and funds that invest in smaller companies tend to charge considerably more, in part because it takes more resources to research those types of stocks.
Fund sales “loads” can add another layer of costs.
In the case of individual stocks, you may be charged a commission when you buy or sell, depending on the type of brokerage account.
What You Can Do: Make sure you’re getting what you pay for in terms of mutual fund management costs: If you’re paying higher-than-average fees, you ought to be getting higher-than-average returns. If not--it may be time to change funds.
A simple way to reduce fund expenses is to stick with index funds, some of which (though not all) have very low costs.
Also note that funds that trade stocks actively incur often “hidden” costs of trading, such as Wall Street dealers’ bid-asked spread on stocks--a higher price to get in, and a lower price to get out, at any given moment.
All told, trading costs for big-stock mutual funds reduce the average fund’s return by about 2% a year, according to Plexus Group, a Los Angeles consulting firm that works with money managers. Trading costs for small-stock funds are significantly higher, sometimes reducing annual returns as much as 9%.
That means your fund managers must beat the market returns in raw terms by at least those percentages just to match the market return as a whole.
Again, if your fund manager is an active trader, and the fund’s annual portfolio turnover is well over 100%, your returns may have to be high indeed to compensate for trading costs.
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Reality Check
Sure, you could have earned returns of nearly 29% a year in the ‘90s by keeping all of your money in technology stock funds. But most people held more diversified stock portfolios, and many owned bonds as well. Result: far lower overall returns--and lower risk as well.
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10-year annualized investment returns*:
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Source: Morningstar Inc.
