The perils of chasing performance

The stock market began its upward march late last year, but despite the nice bump that showed up on quite a few 401(k) statements, many long-term mutual-fund investors haven't benefited from the upturn.

And when the market eventually dips, a lot of those investors will see their portfolios decline even more.

The reason? Market timing - not the shady variety with which some fund companies are being charged, but simple, hope-to-score performance-chasing.

Investors who engage in the practice often wait to invest in a fund until they're convinced its recent performance is good enough. But by that time the fund may have seen the best performance it's going to see for a while. Or, they dump the fund just as soon as it has a few quarters of underperformance. As a result, "the average return of investors in mutual funds is much lower than the average return of those mutual funds themselves," says Mark Sellers, a senior analyst at Morningstar Inc., in Chicago.

The result of this behavior can be seen in a recent study by Dalbar Inc., a financial-services market-research firm in Boston. For the 18 years from 1984 through 2002, the Standard & Poor's 500 index of large-company stocks provided a cumulative return of more than 793 percent and an annualized return of 12.22 percent (see chart, right). That includes the three-year bear market from 2000 through 2002. However, the average stock-fund investor's cumulative return was less than one-twelfth that of the S&P, or about 62 percent.

At the same time, the average investor's annualized return was just 2.57 percent - less than inflation during that period, according to the Dalbar study.

"We knew the [equity-fund] returns would be down because of increased market volatility," says Heather Hopkins, Dalbar's marketing director. "But we did not expect it to push returns below inflation."

Dalbar has been doing this survey for about 10 years, Ms. Hopkins says, but it added a new element this year. The firm examined the effect of political events on investor behavior. These events included the Sept. 11, 2001, terrorist attacks, presidential elections, the first Gulf War, the first World Trade Center attack in 1993, and the Oklahoma City bombing in 1995. None of these events appeared to have much, if any, impact on investor behavior, the survey found. Rather, investors seemed to react almost exclusively to changes in market direction.

As a result, Mr. Sellers says, "too many investors ... end up putting a lot of money in funds after they've gone up and taking it out after they've gone down."

Some investors also overreact to market upturns. "I just got a call from one of our most jittery clients," says Douglas Mollin, a financial planner in Elmhurst, N.Y. "He's been retired for a couple of years now. He asked 'You know, the worst is over. Shouldn't we be getting more aggressive now?' You would think that the pain of the past three years would last a little longer than eight months."

Individual investors aren't entirely to blame for jumping on the bandwagon when certain types of funds are doing well, Hopkins notes. After a period of strong performance by a particular fund, mutual-fund companies will often launch a promotion campaign for that fund.

Nor is employing a degree of informed market timing totally wrongheaded. Some of the best professional track records have been built using it in some form. (The questionable practice now in the news involves fund companies allegedly allowing some timers to jump in and out of funds - even when funds' prospectuses call the practice forbidden.)

Hopkins many financial advisers have done a good job of keeping their clients focused on their long-term goals and have prevented these clients from too much jumping in and out of the market. "Unfortunately, it's not the rule, because we have still seen things like advisers pushing bond funds, which they were doing a month or so ago."

That, by the way, was just before interest rates started increasing, which resulted in lower bond prices.

The best way to avoid sub-par returns, the experts agree, is to avoid chasing the ups and downs of the market. Still, some tactical changes may be in order for investors who are worried about the stock market or who want less volatility in their portfolios.

For example, Mollin says, "you can maneuver around the edges of a portfolio. Say you've got 50 percent of your money in stocks but you have a couple of aggressive funds, like a technology fund. You can stay in stocks but maybe shift toward funds with more consistent performance." He cites Longleaf Partners, Clipper Fund, and Dodge and Cox Stock Fund, all of which are classified as "value" funds and performed relatively well during the 2000-2002 bear market.

"So, rather than cut the 50 percent you have in stocks to 20 percent, sell the most aggressive pieces of the portfolio and replace them with something that might be a little more consistent over the long term," Mollin advises.

"Don't try and outsmart the market," Morningstar's Sellers says. "Buy good funds and hold them." He also recommends investing the same amount of money in a fund every month or quarter.

"Dollar-cost averaging forces you to buy more when stocks are cheap and buy less when stocks are expensive," he says. "It forces you to act the way great investors would act."