Wednesday, November 11, 2009

Investing in Mutual Funds: The Mean Reversion

I'll admit as should everyone who writes about investing, there is no silver bullet, no perfect scenario, no predictable table you can follow when it comes to investing. Some suggest that the only way to come close to a comfortable retirement is to invest in stocks. But they have a limited historic return, somewhere in the vicinity of about 6.3%.

Stock funds do worse according to available statistics. The comparisons here get a bit sketchy. In almost every instance, a stock fund, no matter what it invests in, how well it has done, is compared to the Wilshire 5000, an index that represents the whole of the stock market universe.

But in truth, it doesn't even come close. Any sort of index fund that attempts to mimic that index is unable to buy all of the stocks and some buy less than a fourth of what is available. The reason is easy to see and generally accepted: some stocks are simply to small to buy and any investment of any size by any index fund would drive the price of those stocks up. There simply aren't enough shares available (liquidity) to buy.

This comparison suggests that the real rate of return in stock funds is about 3.9% in part, as some suggest, because of fees. And that is if you are fortunate to have the iron-will to stay invested through thick and thin, ups and downs. Sadly, most of us don't.

Our Investment Expectations
We expect everything that is up to stay up and everything that is down to stay down. This leads us to believe that selling a stock fund as it begins to lose share value in favor of a stock fund that is on the top ten lists for the previous quarter or year. Oddly enough, and this is why economist refer to it as the mean reversion, selling on the way down eliminates the opportunity to buy additional shares and a reduced price because we do not expect the fund to recover.

The real trouble is buying a fund at the top with the expectations that there is still additional upside potential. the knee jerk reaction to such a dilemma is to simply buy an index fund and let it ride. The Bogleheads will love this idea. For those of you who are unfamiliar with this emphatic group, they swear by the index fund. It was not a some might think, created by John Bogle of Vanguard but when the age of computers advanced far enough, he became its leading disciple.

Mutual funds present an interesting opportunity even as they seem to offer you more volatility. Even index funds, left alone from the date of your initial purchase, will suffer fits and starts as it lumbers across a thirty or forty year investment career.

Some of us writing about finance will offer you the realistic possibility that a Treasury Inflation Protected Security (TIPS) could do as well as any investor who bought stocks or stock mutual funds. Fine if you are good with 2.6% over a working career.

Because folks usually purchase stocks and stock funds in the hope they will provide some additional growth and risk that will help fund their retirement, pursuing that path might leave you struggling.

The Best Investment Option
The best option remains the hardest one to execute. Ignore the markets in the short-term and invest across a wide variety of investments. begin with actively managed funds. As your wage increases, add more money in the form of index funds that drill into various sectors deeper than a total market index fund might. As you continue to age, add a bond fund or two, domestic and international.

The key is to find low fee funds as compared to their peer group - not to an index. Find a manager who has navigated rough water in the past and emerged with better than average returns. You will have to go back a few years for that. Keep in mind, you are not looking for an average that is comparable when the fund may have lower lows that the funds in its group and an occasional brush with the top ten performers.

In the case of mutual funds, average is good. It avoids the mean reversion problem that many investors have and keeps your risk level at a much higher rate than fixed income. According to Simon Johnson and James Kwak, writing in the Washington Post recently, the goal is to have enough money to buy an annuity upon retirement, in large part because the gamble of outliving your money is simply too great.

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