Investor Behavior Gap
Morningstar has spent years studying the returns investors actually earn versus the returns the funds earned. Through this study, Morningstar has found that the behavior of an investor whether by attempting to time the market, selling during a downturn or buying after a rally has resulted in the same outcome - the average investor earning a lower rate of return.
Here’s an example - Imagine that a fund with $10 million in assets earns a 100% return from Jan. 1st to Dec. 31st. Assuming no one added or took money out of the fund it would start the next year with $20 million in assets. In the new year investors flocked to this fund adding $100 million on January 1st because of its previous years performance bringing its assets to $120 million. In year two, however, the fund loses 50% of its value. An investor who invested at the beginning of year one has broken even over the full two years while those who entered into the fund in year two have lost 50% of their investment. As a group they gained $10 million in year 1, but lost $60 million in year two. Adjusted for the timing and amount of inflows, the average investor lost about 42% annually in a fund that officially reported a 0% return over the two year period. Simply put, it is unwise to chase performance.
The average investor has underperformed the fund investments they own by an average of 1.6% per year over the long run. Over a 10 year period an investor that underperformed by 1.6% per year would have earned about $300,000 less than the fund itself (assuming a $1,000,000 portfolio, an 8% rate of return by the fund, a 6.4% return for the average investor, and no withdrawals). The gap between the returns tend to be greater for funds that are riskier (equity funds) since they invoke more of an emotional response by investors due to their higher volatility. As financial advisors part of our job is to eliminate that gap for our clients by removing the behavioral mistakes resulting from swings in the market.
On average, trying to do better makes an investor do worse. It feels great to buy more when an investment had been going up, and it hurts to buy more when an asset has gone down. An investor that tends to raise their exposure to assets that have gotten more expensive (with lower future returns) and to reduce it when they are cheaper (with higher future returns) guarantees they will underperform. Why is it that people want to buy everything else on sale except their investments?
In the end, emotional responses to market events significantly hurt the average investors performance.