Quote of the Week: Inheriting Volatility and Your Dollar Weighted Investing Returns

quote of the week dollar weighted returns market volatility

This week, we are looking at the effects of volatility on your portfolio. But not in the effect of just how much the value of your portfolio changes – but in how you ACT due to that volatility and how much it hurts your long term performance.

 

Last week, I was reading the annual report for a fund that I own, Vanguard Dividend Appreciation Index Fund (Ticker: VIG), and at the end of the Chairman’s (William McNabb III) letter found this quote: 

 

“Tim [Buckley – Vanguard’s Chief Investment Officer] and I both stressed that how you react – or don’t react – to such jolts can determine how you ultimately fare as an investor. That’s why one of those key principles highlights the need to maintain perspective and long-term discipline….

Tim noted that the best course for long-term investors is simply to ignore daily market moves. He pointed out that investors “inherit” what would otherwise be fleeting volatility when they sell in response to a market downturn. As Time put it, the only way to truly have a loss is to act and realize that loss.

Those are works to keep in mind when markets turn stormy again.”

 

The full annual report can be found here for those interested: https://personal.vanguard.com//funds/reports/q6020.pdf

 

And we can actually measure what Mr. McNabb is talking about here. There are many reports (such as here, here and here in addition to other cited below) that investors typically “underperform” the stated return for a fund by buying at higher prices and selling at lower prices, in other words reacting to volatility and performance. This is measured by calculating the fund’s “Dollar Weighted Return”

 

Dollar Weighted Return

 

Using a fund’s published inflows (how much money came into the fund) and outflows (How much investors sold the fund) and the price history of that fund, the average investor’s actual return can be calculated. If huge inflows occurred at market highs and large outflows occurred at market lows a more accurate investor return can be estimated. This is referred to as the fund’s “Dollar Weighted Return”. So how do investors typically perform compared to a fund’s official return?

 

Morningstar.com goes into detail on how they calculate a fund’s dollar weighted return (They call it the “Investor Return”) here: http://corporate.morningstar.com/us/documents/PR/Investorreturnsfactsheet.pdf

 

So how much are investors hurting themselves by trying to time the market highs and lows? Marketwatch did a story about a year ago on this:

 

“Russel Kinnel, Morningstar’s director of mutual fund research, raised several key findings that show just how badly investors lag their funds:

  • A year ago, the 10-year gap between the average investor and the average fund was just under 1%; by the end of 2013, it stood at nearly 2.5%. That difference is why the typical investor booked a 4.8% annualized gain over the last decade, while the typical fund gained an average of 7.3% a year.

  • The smallest gap came in domestic equity funds, where the average investor earned 6.5% annualized, compared with 8.1% for the typical fund.

  • The worst investor return came in alternatives, where the average investor lost 1.15% annualized. The average total return for alternative funds wasn’t great, but at least it was positive at just under 1%.

  • The biggest gap between fund performance and investor returns came in international and sector funds, which delivered respectable results to both parties, but where the average fund generated gains at least 3 percentage points better than the typical investor in those funds actually made.”

 

 

To be fair, there is controversy on how a fund’s dollar weighted return is calculated. There is evidence that the average investor’s underperformance may not be quite as bad as reported.

Jason Zweig reported on this in an intelligent investor column that the gap may be smaller than reported by some often cited studies.

 

But the basic premise cannot be argued. Investors generally hurt themselves by buying when the market is hot and selling during downturns.

 

For those interested Morningstar actually publishes the “actual” fund returns vs the dollar weighted, or investor returns for most mutual funds.

For VDAIX (The mutual fund version of VIG) investors have actually done very well:

vdaix_dollar_weighted_returns_vs_total_returns

But a lot of that can be contributed to the bull market over the last 5 years. The market has gone basically straight up…making it tough to underperform the fund’s returns.

 

When we look at a fund with a much longer history, the effect of investor behavior is much more apparent, below we are looking at Vanguard’s S&P 500 index fund (ticker: VFINX):

vfinx_dollar_weighted_return_vs_total_return

 

How does this lagging performance hurt the average investor over the course of their investing life? Tomorrow’s “Chart of the Day” will take a look.

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