Fund investors earn lower returns because of excessive trading

Mutual fund investors are hurting themselves by trading their funds too frequently and buying at the wrong times, concludes a study of mutual fund cash flows by Gavin Quill, senior vice president of Financial Research Corp. in Boston, Mass.  Quill studied the flows of money into and out of stock and bond mutual funds during the 1996 through 2000.  He found that mutual fund redemptions grew sharply during the period. At the beginning, the average investor held his fund shares for 5.5 years, well below the 10-year period generally accepted as the minimum required for long term investing.  By 2000, the average investor held his funds for just 2.9 years.

“Rising redemption rates provide empirical support for the notion that investors have been “behaving badly,” getting into and out of funds much more frequently,” he writes.  Also, redemption rates for investors who buy mutual funds directly were shorter than for those who bought their funds through financial advisors.  Even worse, a study of fund returns compared to flows of money into and out of funds showed that”the average investor consistently underperforms as a result of excessive turnover,” he says.  The study showed that the average return achieved by mutual funds was much higher than the actual returns realized by average investors.  That was due to the investors’ short holding periods and to their tendency to buy high and sell low.

Investors on average throw their money into funds after they have experienced top returns, and also don’t buy funds that have recently underperformed.  “Too often, they will buy into a hot fund or asset class just as it is peaking, ride it down and then switch into the next hot objective just as it is reaching its top,” he writes.  For instance, the average one-year return of all categories of funds listed by Morningstar Inc. during the 1990s was 11.7%.  But the actual one-year average return achieved by the average mutual fund investor during the same period was just 6.7%, Quill found.  Looking at individual investment categories, he found that average mutual fund returns beat actual returns to investors 77% of the time over one-year periods.

Over 25 years, the average investor who started with $10,000 would give up $53,000 in potential gains because of frequent trading, Quill concluded.