There are many variables in investing, unfortunately time is not one of them. Yes, you can extend when you are planning on retiring, or fulfilling a goal, but you cannot go back to when you should have started saving. We’ve all heard the saying “the best time to invest is 30 years ago, the next best time is now.” The truth in that saying is due to one principle: the power of compound interest. Compound interest is simply when your gains start earning gains. At that point your original investment isn’t the only money working for you. There is a snowball effect that takes place and accumulates over time. The problem is, often times we see these returns and then we hear about other returns that might be better, and we get greedy. At that point we start to make mistake number two.
2. Chasing Returns
We’ve all seen the headlines in Money Magazine “Best 100 Mutual Funds”. At conferences I’ve been told that magazine sales skyrocket when these titles appear on the cover. Everyone reads that XYZ fund has done 25% over the last 3 years. But what they don’t see is that investor return and fund return are not always the same.
Investors who buy on advice from friends or magazine are constantly chasing the hottest funds for high returns. When the fund doesn’t perform as well as its past performance, they sell and move on to the next magazine’s “hot” picks. I recently sat through a presentation for advisors from a well known investment research company whose name I cannot mention, that reinforced my thoughts on this topic. While I’m not allowed to mention data from this presentation because it has not been approved for public use, I have found a recent article from Kiplinger magazine citing data from Morningstar that says “Investors earnings are often far less than funds’ reported gains, particularly with volatile funds.” The article “Your Real Total Return” does a wonderful job of illustrating a point many of us in the industry fight clients about when markets get hot.
|VOLATILE FUNDS||SYMBOL||5-YR ANNUALIZED FUND RETURN||5-YR ANNUALIZED INVESTOR RETURN|
|Royce Value Service||RYVFX||19.3||3.1|
|SEDATE FUNDS||SYMBOL||5-YR ANNUALIZED FUND RETURN||5-YR ANNUALIZED INVESTOR RETURN|
|Selected American Shares S||SLASX||9.7||9.7|
It is generally agreed that asset allocation, or the choice of which assets you invest in, account for most (upwards of 95%) investment return. This was first discovered in an unprecedented paper published in 1986 called “Determinants of Portfolio Performance,” by Gary P. Brinson, L. Randolph Hood, and Gilbert L. Beebower. The funds you use to make up your asset allocation should have decent return, and according to the Kiplinger article, low volatility to prevent investor anxiety.
3. Pay too much
Over time, lower expenses can lead to greater return. I’m not the only one who believes this theory. John Bogle, founder of Vanguard says “the shortest route to the top quartile in performance is to be in the bottom quartile of expenses .” He should know; of the 57 funds around from 1981 to 2001, his fund, the Vanguard 500 Index Fund, was tied for the 7th best performer over that time period. (Source: All About Index Funds by Rick Ferri.) For those chasing returns, the trick would’ve been choosing one of the seven funds that beat the Vanguard Fund, AND holding it for 20 years. This feat is probably too much to handle for someone swayed by magazine headlines.
So how does one avoid making these 3 big mistakes?
The best way to prevent procrastination is to have a plan. Studies suggest that having a written investment plan increases your chances of having more money at retirement. A plan gives you focus and accountability. You can reference it over time to see how you are doing, and if necessary, make adjustments along the way.
Avoid chasing returns by putting your faith in an asset allocation that has worked under historical conditions. Remember that asset allocation accounts for over 90% of return. While it may be tempting to chase fund return, the odds are against you.
Keep your costs low by choosing an allocation in low cost index funds. They will never give you the stellar returns we read about, but because of low expense ratios, over time your returns will keep you from falling in the bottom quartile. So maybe you don’t get “the best” returns. Consider the difference an investment in peace of mind.
Rich Feight is a Fee-Only Certified Financial Planner and founder of IAM FInancial, LLC in Michigan. He is also the author of Thinking Beyond Numbers, the financial planning and investment blog that brings awareness to your financial habits so that you can make good decisions. You can learn more about Rich at IAM FInancial, LLC.