Why Investors Underperform by 2% Per Year + How to Improve Your Returns
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Welcome to the Stay Wealthy Podcast. I'm your host, Taylor Schulte. And if you're listening to this on Tuesday, September 14th, please keep me in your thoughts as I'll be on the road coming home from Northern California with three kids under five in my car. My sister-in-law, Emily, just got married, but I don't even think she knows I host a podcast. And I think her husband, Jake, only listens when I talk about Bitcoin and NFTs. But

just in case they're tuning in one more big congrats to both of you. You guys are awesome. Thank you very much for sharing your special day with me. And please, please add some low cost index funds to your retirement savings.

Speaking of low-cost index funds, today I'm sharing some updated data on the gap between fund returns and what investors actually earned. In fact, over the last 10 years, ending on December 31st, 2020, mutual fund investors averaged a return of about 7.7% per year, which is

isn't bad. However, the mutual funds themselves provided a return close to nine and a half percent per year during the same time period. Before I share more, as always, you can grab the links and resources for today's episode by going to youstaywealthy.com forward slash 126.

So this gap between investor returns and total returns from mutual funds is often referred to as the behavior gap. The reason why investors underperformed by almost 2% per year over the last 10 years is not because of hidden fees or taxes.

It's because of poorly timed purchases and sales of fund shares. If investors simply bought and held for the entire 10 year time period, they would not have experienced this 2% gap. And remember, this is 2% per year, which in dollar terms and compounded over 10 years, that can turn into meaningful amounts left on the table.

By the way, this research and the data that I'm sharing today is a result of a study that Morningstar does every year called Mind the Gap. I'll link to it in the show notes. But this gap, this 1.7% gap between investor returns and total returns is in line with the four previous rolling 10-year periods that they've tested. The gap has been between 1.6 and 1.8 percentage points per year each time they've run the study.

What I really love about their study is that they test different asset classes. And what I found refreshing is that plain vanilla stock and bond funds had a smaller gap, 1.17% and 1.12% respectively.

Even more refreshing to see was that asset allocation funds like target date funds have an even smaller gap at 0.69%, suggesting that their built-in diversification benefits and that hands-off approach really helped investors stay committed to the long-term.

I've talked about target date funds in the past on this podcast, and I've actually shared some reasons why I'm not really a big fan of them. But this is definitely one of the pros to using a target date fund or an asset allocation fund. What's really crazy to see is how large the behavior gap was for more exotic asset classes like sector funds and alternatives.

which both hovered around 4% per year, which is more than twice the gap for the aggregate results of this study, which means these two asset classes on their own are a big contributor to that 1.7% average gap. You remove them from the study and you're likely to see the average gap of around maybe closer to 1%, which is a bit more palatable and likely more representative of your traditional retirement saver.

The study also zeroed in on volatility of the underlying funds and found that more volatile funds had a larger behavior gap. For example, the most volatile quintile of taxable bond funds saw a 2.3% return gap per year, but the least volatile only saw a gap of 0.6%.

These results help to support why I'm such a big advocate of making sure your safety net, i.e. your bonds, are truly invested safely. Corporate bonds, junk bonds, convertible bonds, and high-yield bonds, all of these things increase risk and volatility and can not only cause issues when you're in retirement and using your portfolio to create income, but as we can see here, also cause behavioral issues.

The last thing that most people want is to see volatility in both their bonds and their stocks. By the way, the results were similar for stocks. The most volatile quintile of U.S. stock funds had a return gap of 1.7% per year, while the least volatile group had a gap of 0.9% per year.

Two important things to acknowledge while we're on this topic is that one, Morningstar is not the only company to study the behavior gap. The Dalbar study is another popular one that has come to similar conclusions about investor behavior. And two, both of these studies and their methodologies have been criticized by finance experts suggesting that the gap doesn't exist or it's much smaller than these studies lead you to believe.

You can Google around to read more about some of the criticism. I'm not going to dig into that here today. But I thought my friend Colin Roche at Pragmatic Capitalism had a really good take on all of this recently when he made the point that 60% of investable assets are still being invested in high cost assets.

actively managed mutual funds. And since 80% of those high cost active funds underperformed the broad market indexes, it's pretty safe to say that the behavior gap is a real thing. For example, you know, even if all of those investors buy and hold their high cost actively managed funds, naturally 80% of them are going to underperform and experience a gap between their returns and the benchmark.

He went on to say, quote, I don't know the exact cause of the behavior gap, and I don't think I really need to. All I know is that the investment world is a minefield of expensive options that the average investor has a very difficult time actually understanding and navigating.

Financial literacy is a mind-bogglingly huge problem in the USA and around the world. And while people who buy stocks and bonds are probably relatively financially literate, there's still huge amounts of evidence that these investors make bad decisions pretty consistently.

To bring us home here on a more positive note, Morningstar shared four things that retirement investors can do to improve their returns as a result of the recent Mind the Gap study. Number one, keep it simple and stick with plain vanilla, broadly diversified funds. Number two, automate routine tasks like setting your asset allocation targets and periodically rebalancing.

Number three, avoid exotic concentrated funds as well as those with higher volatility. And number four, embrace techniques that put investment decisions on autopilot like dollar cost averaging. And while it likely goes without saying, trading activity is counterproductive. In other words, the more you trade, the more likely you are to underperform.

Choosing an investment plan that you can stick with, that matches up with your goals, your risk tolerance, your risk capacity, and doesn't cause you to panic or lose sleep will produce the best results for you over a long period of time.

From the links and resources mentioned today, head over to youstaywealthy.com forward slash 126. Thank you as always for listening and I will see you back here next week. This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial or other professional services.