Mutual fund investors who trade too much pay too much
By Laura Bruce • Bankrate.com

If your retirement plan is full of mutual funds, you could do yourself a big favor by making two New Year's resolutions: cut back on trading and learn when it's right to buy or sell.

A recent study shows that mutual fund investors in general churn their accounts so much and time it so badly that they significantly reduce returns, losing an average of 20 percent over the past decade.

The mutual fund portion of a retirement plan could experience an even bigger loss.

Experts say it's reasonable to assume that investors might trade even more frequently in retirement plans because they don't see a tax consequence and, in the case of 401(k)s, there are no commissions.

Frequent trading is compounded by a problem familiar to many investors: buying high and selling low.

Backward investing
Gavin Quill, author of the study and director of research at Boston's Financial Research Corporation, says that happens because, on average, people invest too emotionally.

"They buy what was hot yesterday. They buy things relatively overpriced and avoid the things that are underpriced or well valued; in other words, the dogs. They're trading by looking in the rearview mirror. They miss the upside and capture the downside."

Combine a strong tendency to chase overvalued funds with excessive trading and you end up with a sorry-looking portfolio.

An employee who basically neglects his or her 401(k), picking several funds and never doing anything but making regular payroll contributions to the plan, would do better than someone who chases the hot funds.

Using returns gathered over a three-year period and extrapolating them out for 25 years, Quill found that a $10,000 investment would grow to $123,000 if an investor stuck with a fund portfolio throughout the 25 years. That same investment, in the hands of the typical mutual fund investor in Quill's study who's trading a lot, buying high and selling low, would grow to only about $70,000. That's a $53,000 difference come retirement time.

Quill believes the enormous amount of financial information that's available is a major factor in these bad investing decisions.

"People are chasing the latest CNBC hot tip. If you didn't have the explosion of financial information, I doubt you'd have the explosion of rapid turnover trading. We've had a fundamental shift from value investors who buy low and sell high to people who say, "I'll buy high and sell higher."

Quill also found that self-directed investors -- people who don't use a financial adviser -- do worse than mutual fund investors who consult a professional. That's a problem for most 401(k) participants because they usually don't get investment advice.

"There's no intermediary to help balance your emotions, no dispassionate third-party professional to help you on the right course," says Quill.

A little knowledge is dangerous
Jonathan Sard, a certified financial planner with Atlanta-based Financial Alternatives, says too many self-directed investors think they can research the data themselves. In reality, most don't understand it.

"They log onto a site and do their research, which may include just seeing what a Goldman Sachs analyst says about a stock or what Morningstar says about a fund. If they were to read a prospectus, 99 percent wouldn't know what they were reading. I don't think people have the time or the inclination to do it if they're working 8 to 10 hours a day."

Don Schreiber, a certified financial planner with Wealth Builders Inc., in Little Silver, N.J., says many people fail to understand what their investments are supposed to do for them.

"They invest on a random basis. They have a few bucks and plunk it into an investment. They don't know if it will help their retirement goals. What does the investment have to do? Does it have to make a 10-percent return?"

So is this just a pitch to hire a financial adviser? In part, but hiring one simply to do a one-time review of all your assets, including your retirement plan, should be a consideration.

"It's worth the while of every employee to pay a fee to a certified financial planner to get some advice on how to allocate their portfolio," says Robert Veasey, president of the Rhode Island chapter of the Financial Planning Association.

"I feel for the average employee," says Veasey. "They're all alone and they're in an environment where there's a lot of peer pressure. Everyone else is putting money in this or that."

Schreiber suggests finding a financial planner who understands your goal is to make sure your 401(k) is allocated correctly. But be prepared to do some homework. Gather information the planner will need to do an analysis of your financial situation.

"I would require an understanding of current income, current expenses, I'd want to get an idea of what they'll spend in retirement," says Schreiber. "I'd want to know their savings patterns, their contributions to a 401(k) or an outside savings plan -- a cash flow analysis."

If you choose to go it alone, you'll have even more homework to do.

Know thy investment self
Avoiding the pitfalls of trading too often and buying high and selling low takes discipline, strategy and an understanding of what makes you tick psychologically when it comes to your portfolio.

The two psychological factors that influence investors the most are fear and greed.

Investors fear not making money.

"They fear this time is different," says Veasey. "This is the market that will stay down forever and I'm the most unlucky investor that's ever lived and I'll be the first one who's lost money over a 10- to 15-year period."

Greed kicks in when investors buy high thinking the market will go higher when, in fact, it's likely to begin a downward cycle. Greed also surfaces when investors refuse to see the downside and stay invested in a fund that clearly has problems.

Knowing when to sell is one of the most difficult areas of investing.

"I'd have to see an extended period of proof -- two cycles of the market -- a major up and down cycle," Veasey says. "If the fund does poorly in comparison to its peer group and to its benchmark, then maybe something's wrong and it's time to sell."

Whether you go it alone or have an adviser, it's important to know your investment objectives, your time horizon, your risk tolerance and the growth rate you'll need from various investments. All of those factors help determine asset allocation.

When investing for retirement, think long-term. Gavin Quill says five years is the shortest period that could be considered long term. It takes discipline to let a fund sit in your portfolio for that long, but you're more likely to see a bigger return.

Don't try to time the market. If you jump in and out of the market you'll miss the relatively few best trading days of each year. Miss out on those days and your returns will be significantly reduced.

"If you're considering changing investments because of what the market is doing, ask yourself if anything has changed in your life. If the answer is no, then why are you making changes," asks Jonathan Sard. "When the market is volatile, stay the course and don't make knee-jerk changes."

Hiring a financial planner for a one-time consultation on your portfolio is probably the smartest move a self-directed investor could make. But if that's not for you, another option is to use your favorite search engine to find financial planning software that can help with retirement portfolios. Morningstar.com is one of several sites offering a wide selection of tools to assist you in determining whether a fund is right for your portfolio.

Get a strategy and stick with it. Don't churn your account. If a broker churned your account, you'd file a compliant. Understand your biases and learn to set them aside. A balanced portfolio that holds investments picked for the right reason will make money and let you sleep at night.

-- Posted: Dec. 28, 2001