What Really Determines Your Long-term Investing Results? 113 Now let's consider an actual example. The Putnam OTC Emerging Growth Fund sounds like a risky fund. 1 The name implies it invests in over-the-counter companies that are small, and hence just emerging, and that the emphasis is on growth. This provides the potential for large payoffs. Indeed, that was the case in 1999, with a performance of 127 percent. Clearly, if you owned this fund in 1999, you gained bragging rights among your friends. Everyone knows the market suffered a decline in 2000 and 2001, and Putnam Emerging Growth was no exception. The fund was heavily invested in technology stocks. It lost 51 percent in 2000, and another 46 percent in 2001. So, how did an investor do for those three years? At first, it might seem the investor emerged okay. After all, +127 percent, ­51 percent, and ­46 percent = +30 percent, which divided by three equals +10 percent a year, on average. So, is the investor still ahead? Definitely not! The power of compounding is now working against the investor. For that three-year period, the compound growth rate is actually about ­16 percent. It is calculated like this: Assume a $10,000 initial investment. At the end of the first year, the investor had $10,000 × 127 percent, which translates to $10,000 × 2.27 = $22,700. At the end of the second year, the investor had $22,700 × ­51 percent, which translates to $22,700 × .49 = $11,123. At the end of the third year, the investor had $11,123 × ­46 percent, which translates to $11,123 × .54 = $6,006. This is equivalent to compounding over this three-year period at a rate of ­15.63 percent annually! Note the negative sign here--we are going backward, decreasing wealth rather than increasing wealth. Always remember, great performance tends not to last, and investors often end up buying yester- day's hot performers, not tomorrow's. When negative returns get mixed with positive returns, the final results are often a disaster. Costs It costs money to run a fund, and shareholders have to pay these costs. It stands to reason that the higher the costs, the less the net return, other things being equal. Think of a fixed investment that returned 10 percent a year, compounding year after year with essentially no expense involved (if, of course, you could find such an investment). This investment will outperform many mutual funds even if they can consistently earn a higher rate because the fund has to deduct the costs of oper- ations. Ignoring the load charge, the annual operating costs of the typical equity fund will be approximately 1.4 percent of assets per year, and this is a direct deduction from the investment returns of the fund. As we saw when we considered classes of shares, redemption fees and higher 12b-1 fees might be involved, depending on which share class the investor owns. Taxes Investors using mutual funds for retirement accounts do not face the problem of year-to-year taxa- tion, although they must eventually pay taxes on these funds. Investors using mutual funds in regular taxable accounts do face some tax issues, mainly lack of control over the timing of the distributions from the mutual fund. Of course, these issues apply to direct investing as well as to any alternatives to mutual funds investors might consider. 1 The impetus for this example comes from Michael Maiello, "Hall of Shame," Forbes, February 4, 2002, p. 92.