The Easy Way to Beat the Average Investor

At the end of 2012, more than 92 million Americans held mutual funds, many with the intention of selecting market-beating funds. Analysis from Morningstar over the course of 10 years now shows that most of these investors aren't beating the market -- they're beating themselves. In reality, a buy-and-hold strategy relying solely on one broad ETF such as the Vanguard Total Stock Market ETF will significantly outperform most mutual fund investors.

From 2002 to 2012, mutual funds chalked up a 7.1% annualized return despite periods of volatility and widespread investor uncertainty. Investors, however, saw returns of just 6.1% -- a full percentage point short of the market average. This disparity can be largely attributed to frequent trading, often correlated with overall market performance. Inflows to mutual funds rise with the market. But as the market falls, many investors withdraw or postpone investments until signs of recovery. As the data shows, this approach backfires -- investors are simply bad at timing the market and miss significant upside.

For long-term investments, even a 1-percentage-point difference in annualized performance is critical. A recent report from the Investment Company Institute (link opens PDF file) shows that 93% of fund investors are doing so to save for retirement. Applying these rates to a basic long-term scenario, a one-time investment in 2002 that achieved market-matching returns was worth almost 10% more in 2012 than a comparable investment at returns seen by the average investor. If rates remain unchanged, the difference in investment value increases to 33% after 30 years.

Similarly, fees have important implications for long-term investing. The asset-weighted average of expenses for equity mutual funds stands at 0.77%, projected to continue declining gradually. A mutual fund's trading costs, which are not required to be disclosed, may be more dangerous to fund investors, though. A study in Financial Analysts Journal reported that mutual fund investors pay an average of 1.44% in trading costs. Moreover, the high trading costs cannot be justified by higher returns. Researchers found "a strong negative relation between aggregate trading cost and fund return performance."

What better way to match market returns than indexing with ETFs? Unsurprisingly, the Vanguard index ETF mirrored the 7.1% average annualized return from 2002 to 2012. With low fees, low or no trading fees, easy entry, and one-step diversification, total market or broad ETFs are ideal candidates to outperform the average fund investor. The Vanguard ETF is one such fund, although Fidelity, iShares, and Charles Schwab also have comparable total market index ETFs. At a mere 0.05%, the Vanguard ETF's expense ratio is lower than 95% of funds with similar holdings and is completely out of the typical mutual fund's league.

Imagine the time savings associated with finding a broad ETF. You don't have to decide which funds you will invest in next month or next year, an ordeal that may cost you hours upon hours of your personal time. You don't have to decide when to withdraw or move money because of a market pullback or poor fund performance relative to the market. (Usually to no avail, mind you.)

While average returns in coming years may vary widely from Morningstar's recent findings, the gap between the market's average returns and the fund investor's average returns will remain. With the Vanguard Total Stock Market ETF, you can be sure you won't shoot yourself in the foot and can avail yourself of a strong anchor for a diversified portfolio.

Think you might have an advantage over the average investor? Check out Morgan Housel's recent article: "Who Should Try to Beat the Market?" 

To learn more about a few ETFs that have great promise for delivering profits to shareholders, check out The Motley Fool's special free report "3 ETFs Set to Soar." Just click here to access it now.

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Fool intern Grant Heskamp has a position in VTI. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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