Mutual funds use annual returns as advertisements to attract investors. Investors are customers for managed mutual funds, and the better the annual returns, the more likely the fund will be to attract investors. Track the actual investor performance for someone who invests in a mutual fund, it often diverges greatly from the advertised performance. This is because the advertise fund performance assumes an investment at the end of one period and a measurement at the end of another period. Real investors just don’t time their investments that way.
For example, take a steadily-growing fund. In 2010, this fund increased at a rate of 1% each month, with a total of 12% for the year. (I’ve simplified the returns in this example.) If the investor purchased the fund at the very end of 2009 and sold the fund at the very end of 2010, she might have experienced that 12% increase.
- Most investors don’t invest dump sums, the invest periodically, when they have the money. In this example, with an investor investing once a month, each successive investment would be at a higher price, reducing the overall return. Only shares purchased at the beginning of the period would see a 12% increase.
- Most funds do not have such steady growth. A month of 15% return might be followed by a month of 25% loss, even when the same 12% annual result is achieved. Periodic investments with uneven growth result in actual investment returns that can swing wildly from the advertised returns.
- Along with unsteady growth, advertised returns don’t take into account the order of returns. From a fund’s perspective, there is no difference in annual returns whether the 15% return occurs at the beginning or the end of the year. From the investor’s perspective, more money is invested in the fund by the end of the year, so the last month has a larger effect on the overall investor return than the first month.
A recent article from Vanguard illustrates this well. As one invests throughout the year — or throughout a lifetime — it’s recent performance that has the most effect on whether an investment performs well. Retirees who sold investments after the market crashed in the recent recession have experienced this first-hand. The best investors can do is hope for low returns during the investment phase, and a great increase right before selling is necessary. While over the long term, stocks return 8% annually after taxes, most investors continue investing during that overall increase, reducing effective returns. Even when invested in a broad stock market index fund, bad recent performance will sour a lifetime’s worth of investment.
Most importantly, don’t expect to receive the same return advertised by a mutual fund.