How to Avoid Investment Mistakes with Mutual Funds

Individual investors have made predictably poor decisions allocating their investment capital in response to increased stock market volatility in recent months. The disciplined approach to allocating capital followed by advisors who use Dimensional Funds avoids this mistake and leads to higher returns.

Menlo Park, CA (PRWEB) August 4, 2006 -- As market volatility has increased in recent months, individual investors have made predictably poor decisions allocating their investment capital. As is typically the case, instead of following a disciplined approach to deploying their investment dollars, investors have moved billions from stocks to cash in an emotional reaction to recent price declines.

"It is easy to understand this has happened," says Dan Goldie, a financial advisor to wealthy individuals and families in Menlo Park, California. "Market jitters are being felt around the world as economic and political uncertainty have grown. The natural inclination in times like these is to become cautious, especially when putting new money to work." Evidence of this behavior can be seen in recent mutual fund cash flows. Just last week alone investors pulled $5.25 billion out of stock mutual funds according to Trim Tabs Investment Research, and have withdrawn more than $15 billion since May. Nearly all of this occurred after markets had already declined.

According to Mr. Goldie, "Rather than using the recent pull back as an opportunity to buy shares at lower prices, or at the very least just staying put, investors are increasingly making the mistake of selling at the wrong time and for the wrong reasons. This is a normal emotional response, but not an optimal one."

Researchers have noted this pattern in previous market cycles, resulting in reduced returns for individual investors over time. Studies show a strong correlation between market movements and mutual fund cash flows. The correlation figures explain investor behavior as an after-the-fact reaction to market declines where investors tend to sell those funds that have done the worst (usually the most aggressive equity funds) and buy those that have done the best (generally conservative bond funds or money market funds). This timing hurts investors’ returns, as they tend to buy near peaks and sell near troughs.

A Disciplined Approach

A disciplined approach to allocating new investment dollars, or even rebalancing existing assets, involves a cash flow pattern that is the opposite of what is observed. Mr. Goldie comments, "If investors followed rational and more profitable investment policies, they would increase their new investment in stocks after a market decline rather reducing it."

The reasoning is simple, if one is investing new money according to an policy with stated allocation targets, not only is it necessary to allocate new money across all asset classes, but also to allocate more to the areas that have declined the most as these are the most underweighted. If the decline was severe enough to warrant a portfolio rebalancing, a similar cash flow pattern would emerge--the weak performers would be purchased and the strong performers sold.

Evidence from Dimensional Funds

Mr. Goldie says, "A disciplined deployment of capital improves investment results. Evidence of this can be seen in the returns of the mutual funds managed by Dimensional Fund Advisors, which limit access to their funds to professional investors such as large institutional investors or the clients of approved investment advisors."

Dimensional restricts access to their funds in part to help maintain a steady flow of money into their portfolios. By only working with professional investors who understand and incorporate disciplined asset allocation policies, Dimensional’s cash flows are not subject to the extreme fluctuations that most other fund families experience. Dimensional believes this improves the returns of their funds.

Mr. Goldie continues, "It is possible to measure the efficiency with which a mutual fund is able to transfer its return to shareholders. This is done by comparing the return achieved by the fund, called the time-weighted return, to the return earned by shareholders, called the dollar-weighted return. These numbers will differ due to the cash flow activities of shareholders. A more disciplined shareholder base will achieve higher dollar-weighted returns if they avoid buying and selling at the wrong times."

The figure below shows data from the Morningstar 2005 Yearbook for the 10 years ending December 31, 2005:

Dimensional Funds
Returns to Funds (Time-Weighted) 9.90%
Returns to Investors (Dollar-Weighted) 10.81%

All No-Load Index Funds
Returns to Funds (Time-Weighted) 8.65%
Returns to Investors (Dollar-Weighted) 7.07%

According to Morningstar, the returns received by Dimensional shareholders in the last decade was not only higher than shareholders of other funds, it was higher than the time-weighted returns of the Dimensional funds themselves! This means that Dimensional shareholders, through the steady deployment of new cash and consistent portfolio rebalancing, actually improved their returns beyond those generated by the vehicles in which they invested.

Morningstar says these results, "suggest advisors who use DFA encourage very smart behavior among their clients, even buying more out-of-favor segments of the market and riding them up, rather than buying at the peak and riding the trend down, which is usually the case with fund investors."

Long-term investing requires discipline and patience. Of course, this is much easier said than done, but rewards do come to those who follow these ideals.

Dan Goldie is a financial advisor to wealthy indviduals and families. He is located in Menlo Park, California. Investment Advisory services provided through Partnervest Advisory Services LLC.

For further information contact:
Dan Goldie
750 Menlo Avenue, Suite 200
Menlo Park, CA 94025
650-566-1121
http://www.dangoldie.com

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