Investment Returns Are Not Always What They Seem

Checking past returns on investment options is an important part of our finance routine. When preparing to make a new investment we look at what the fund has done in different time frames, whether it is MTD, the past quarter, YTD, 10-year or since inception. We use this information to compare performance with its peers and against the market in general. We also use this ongoing information to track our investment performance over the years to make sure our investments are on track. Unfortunately, the data published by sources such as Morningstar, Yahoo or Forbes is simply a “real return” number and it very rarely matches up with our personal returns.

The December issue of Money Magazine briefly touches on this issue and states:

Since 1996 the typical stock fund earned an annualized 8.8%, while shareholders made just 7.3%. That gap is the price the average investor paid for chasing hot performance.

The reason behind this is simple; investors don’t always invest the way the research sites track returns. These returns are based on a lump sum investment that is purchased on a certain date and held for a certain length of time. While investors do occasionally invest this way, more often than not it is more complex.

If you were to buy X amount of shares of a mutual fund on January 1 and held it, then yes your YTD return as shown on any finance website would essentially match your actual returns. But what about investments in your 401(k) or IRA accounts where you regularly make small purchases into these funds? For example, if you add $500 per month into a certain investment over the course of the year, your cost basis is significantly different than buying $6,000 on January 1 and holding it. Depending on fund performance, your actual return may be significantly higher or lower than the reported YTD return shown by the various websites.

Another factor, which I quoted above is the fact that it is human nature to chase returns. I see it everyday when helping people allocate their 403(b) funds. They meet with me to change their allocation and more often than not, they add more money into the funds that have been recently performing better and take money out of funds that have been laggards. Again, this plays a significant role in their actual return when compared to the real return of the fund.

This isn’t to say that basing part of your investment decisions on returns is not important, but it is important to understand that those returns are only as real as your own investment activity. A while back I talked about Morningstar adding a new metric to their fund information, or dollar-weighted returns (Investor Returns). This new method tracks the inflow and outflow of money into a fund to create a more realistic return most investors have actually seen with the fund.

In the end it comes down to developing a properly diversified portfolio for your investment objectives and sticking with it. Chasing returns or adding more money to outperforming funds or pulling money from under performing funds may yield a quick boost to your returns, but may ultimately skew your investment allocations away from your original objective over the long-term.

Author: Jeremy Vohwinkle

My name is Jeremy Vohwinkle, and I’ve spent a number of years working in the finance industry providing financial advice to regular investors and those participating in employer-sponsored retirement plans.

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