Failure of Most Portfolios to Outperform the Relevant Benchmark on a Risk-Adjusted Basis

Investors are betting on continued good performance when they buy many funds, and such performance simply does not always materialize. In many cases, the issue becomes one of the fund performing as well as some other investment with a steady rate of return. In the case of equity mutual funds, the other investment can be thought of as an index fund.

Let's consider this issue in more detail. Investors often make critical mistakes in thinking about a series of returns on their investments. They think, wrongly, that if the performance is really great one year, it will offset one or more bad years . Maybe it will, but often it does not.

Start with an easy example. Your mutual fund earns 50 percent this year. Next year, you lose 50 percent. Are you even? Hardly. Although +50 percent and “50 percent average out to zero, that is not how compounding works in the world of investing.

Let's assume we start with $10,000, and our fund gains 50 percent the first year. We then have $15,000, because we add $5,000 to our beginning investment of $10,000. During the second year, we suffer a 50 percent decline. The loss in dollars is now $7,500 because the amount invested is larger, leaving us with only $7,500. At the end of the second year, we are certainly not back where we started.

Now let's consider an actual example. The Putnam OTC Emerging Growth Fund sounds like a risky fund. [1] The name implies it invests in over-the-counter companies that are small, and hence just emerging, and that the emphasis is on growth. This provides the potential for large payoffs. Indeed, that was the case in 1999, with a performance of 127 percent. Clearly, if you owned this fund in 1999, you gained bragging rights among your friends .

[1] The impetus for this example comes from Michael Maiello, "Hall of Shame," Forbes , February 4, 2002, p. 92.

Everyone knows the market suffered a decline in 2000 and 2001, and Putnam Emerging Growth was no exception. The fund was heavily invested in technology stocks. It lost 51 percent in 2000, and another 46 percent in 2001. So, how did an investor do for those three years?

At first, it might seem the investor emerged okay. After all, +127 percent, “51 percent, and “46 percent = +30 percent, which divided by three equals +10 percent a year, on average. So, is the investor still ahead? Definitely not! The power of compounding is now working against the investor. For that three-year period, the compound growth rate is actually about “16 percent. It is calculated like this:

Assume a $10,000 initial investment. At the end of the first year, the investor had $10,000 x 127 percent, which translates to $10,000 x 2.27 = $22,700. At the end of the second year, the investor had $22,700 x “51 percent, which translates to $22,700 x .49 = $11,123. At the end of the third year, the investor had $11,123 x “46 percent, which translates to $11,123 x .54 = $6,006.

This is equivalent to compounding over this three-year period at a rate of “15.63 percent annually! Note the negative sign here ”we are going backward, decreasing wealth rather than increasing wealth.

Always remember, great performance tends not to last, and investors often end up buying yesterday 's hot performers, not tomorrow's. When negative returns get mixed with positive returns, the final results are often a disaster.



Mutual Funds(c) Your Money, Your Choice... Take Control Now and Build Wealth Wisely 2002
Mutual Funds(c) Your Money, Your Choice... Take Control Now and Build Wealth Wisely 2002
ISBN: N/A
EAN: N/A
Year: 2004
Pages: 94

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