How Investors Really Fare in Mutual Funds

An all-too-common investing error can erode your fund returns.

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Investors typically pay attention to funds' published returns to gauge their performance over time periods such as one, three, and five years. But there's another measure of performance that tells a different story. Morningstar calculates what it calls investor returns, which reveal how much money investors actually make or lose in a fund over time. And the difference can be huge. That's because, by using "dollar-weighted" returns to measure how your own dollars fared while in the fund, Morningstar takes into account an all-too-common investing error: buying funds when they're flying high and dumping them when they fall behind.

The more volatile a fund is, the lower its investor returns tend to be. Take CGM Focus. The fund has gained a whopping 18 percent per year, on average, over the past 10 years, placing it in the top 1 percent of its large-cap growth category. But according to Morningstar's calculations, the average investor lost about 11 percent in that time period. That's likely because investors tend to pour into funds after big run-ups—in CGM's case, 2007, when the fund rocketed 80 percent—and sell their shares into a drop-off.

[See U.S. News's list of the Best Mutual Funds for 2010, and use our Mutual Fund Score to find the best investments for you.]

Although the behavior of bond funds is generally more tame, the behavior of investors doesn't necessarily change. The Dodge & Cox Income fund, which typically holds riskier assets than its peers, saw investor outflows in 2008 stemming from their reaction to the financial crisis. It held up relatively well during the downturn and investors returned, but many of them missed out on gains. Over the past 10 years, the fund has returned an annualized 7 percent, while the average investor saw gains of only 5 percent. "You do have these shocks to the systems every five or seven years and when they do happen, you'll often have people getting out right at the bottom or coming in right after a rally, so some of the same rules apply with bonds as well as stocks," says Russel Kinnel, Morningstar's director of mutual fund research.

There are some cases in which published returns and the amount that investors actually earn is about even. This tends to happen in less volatile funds that take some of the emotion out of investing, such as index funds (the Schwab S&P 500 Index fund's 10-year annualized returns and its investor returns are both virtually zero) and balanced funds. Over the past 10 years, on average, Vanguard Wellington's total returns and investor returns were virtually even. In any given year over the past decade, the fund never gained more than 20 percent, but it also never lost more than 23 percent, which made for a smoother ride than many other funds experienced.

[See The 100 Best Mutual Funds for the Long Term.]

Kinnel says investors often put too much faith in the short-term performance of funds. Frequently, he says, high one- and three-year returns are contrarian indicators—meaning that asset class may be overheated and investors should consider looking elsewhere. "Recognize that one- and three-year returns don't mean much about what to expect in the future," he says. "People need to wean themselves off the short-term returns data."

Above all, Kinnel says, "People need to take into account risk, and they need to have a real portfolio plan. That helps provide guidance for what you should do as opposed to collecting funds that lend you to panic and forget why you bought them in the first place."