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Over the last 10 years, the average mutual fund and exchange-traded fund gained about 7.7% per year.
The average person investing in those same funds, on the other hand, only gained about 6% per year during the same time period. In other words, investors underperformed the exact funds that they were investing in by about 1.7% per year over the last 10 years. And contrary to what you might be thinking, investors did not underperform because of high fees or taxes.
Investors underperformed because of poorly timed purchases and sales of the funds. They underperformed because of their investing behavior. And that's precisely why this gap between the average investor's return and the average fund return is widely referred to as the behavior gap.
Welcome to the Stay Wealthy Podcast. I'm your host, Taylor Schulte, and today I'm discussing the recently updated Mind the Gap study published by Morningstar. I'm sharing what asset classes had the highest and lowest behavior gap over the last 10 years, the role volatility plays in investing behavior, and three things retirement investors can do to earn more of their chosen investment fund's total returns. To
To grab the links and resources from today's episode, just head over to youstaywealthy.com forward slash 199. To recap, the average mutual fund and exchange traded funds total return for the last 10 years ending December 31st, 2022 was 7.7% per year. The average investor's total return in the exact same funds over the exact same time period was 6% per year.
Put simply, investors missed out on about one-fifth of their fund investment's average net returns over the time period measured. And these results have been consistent year after year, decade after decade. Investors, on average, continue to be negatively influenced by their emotions and behaviors, leading them to make poorly timed buying and selling decisions. It turns out that buying and holding is much easier said than done.
As my friend Carl Richards puts in his book titled The Behavior Gap, quote,
He goes on to say...
Investors as a group tend to be horrendously bad at timing the market. It makes far more sense to ignore what the crowd is doing and base your investment decisions on what you need to do to reach your goals. But man, is that hard to do. It's not that we're dumb. We're just wired to avoid pain and pursue pleasure and security. It feels right to sell when everyone around us is scared and buy when everyone feels great.
It may feel right, but it's not rational.
I think one of the traps many of us fall into, myself included, is that we think we know better. We think we're smarter than the investors that are often referenced in these studies. We think that we can avoid falling victim to the behavior gap because we're a financial expert or we're students of the market. And then we get caught off guard and we make a poor decision with our money or investments, reminding us that we are all in fact human. As Carl put it, we're all wired to avoid pain and pursue pleasure and security and
And in my mind, admitting that our emotions can lead or even tempt us to make irrational money decisions is an important step. It creates space for us to learn how we can narrow the behavior gap for ourselves and make better decisions with our hard-earned money.
Knowledge is power, but only if we're open to absorbing the knowledge, learning and improving and trying to get better. I've read Carl's book more times than I can count, but every time I open it, like I did for today's episode, every time I open it, I walk away with something new and helpful that reinforces and advances the knowledge that I've gained over the last two decades.
And I'm reminded that mastering our behavior, especially as it relates to money and investing, is not like riding a bike. It's more like playing golf. It requires ongoing attention, practice, and a whole lot of patience. So while the Stay Wealthy community likely is not representative of your average investor, you guys are very smart, I still think that we can benefit greatly from continuing to study reports like the Mind the Gap paper from Morningstar.
So with that, let's dive into three key takeaways from their most recent study. The first takeaway is that sector funds have the highest behavior gap out of all the investment categories. Over the last 10 years, investors underperformed the very sector funds they were investing in by 4.38%, almost three times the weighted return gap for all categories. So
Sector funds are funds that invest in companies that operate in a particular industry or sector of the economy. For example, healthcare, semiconductors, energy, or financial services for that matter.
Interestingly enough, sector funds on average had the highest average annual return of 10.8% out of all categories measured over the last decade. But again, investors in those funds significantly underperformed, achieving an average annual return of only 6.42%.
The category with the smallest behavior gap, by the way, which has been consistent every year this study has been done, was asset allocation funds. Asset allocation funds over the last 10 years had an average annual return of 6.44%, while investors in those funds had an average return of 5.98%, a gap of only 0.46%. U.S. stock funds had the second smallest gap of 0.79%.
The second key takeaway I wanted to share with you today is that large cap U.S. growth stocks did not have a behavior gap at all. In fact, investors in these funds outperformed by about 0.1%. However, this is likely more of an outlier than a trend, given that the behavior gap has been fairly significant for this asset class in all prior years that this study has been done. The popularity, excitement, and healthy performance of
of large growth stocks are likely contributors to investors being able to hold on and outperform over the last 10 years.
On the other hand, emerging markets and international large cap stocks had the two highest behavior gaps during the time period measured of 1.69% and 1.35% respectively. In other words, investors had a much easier time over the last 10 years buying and holding U.S. growth stock funds that own companies they're likely more familiar with than overseas funds.
The third takeaway from the study to share with you is that investors are more likely to experience a larger behavior gap when investing in more volatile funds. And this applies to categories outside of stocks as well. For example, investors in U.S. taxable bond funds
with the highest volatility over the last 10 years, underperformed the funds they invested in by just over 2% per year on average. However, investors in the least volatile taxable bond funds only underperformed by 0.85%.
These results, which by the way have been consistent in this category year over year, reinforce why I remain a big advocate of owning safe AA, AAA rated bonds that don't typically begin to behave like stocks during catastrophic time periods. Not only do highly volatile funds present unwanted risks to a retirement portfolio, but they also increase the chances that an investor's behavior gets the best of them.
For what it's worth, bond funds were not the only category to highlight the relationship between volatility and the behavior gap. On average, investors in the least volatile funds across all categories underperformed the funds they invested in by around 0.9% per year over the last 10 years, which was a full percentage point less than the most volatile funds.
So in short, investors are able to stick with lower volatility funds and earn more of their fund investments total returns than higher volatility funds. As I've talked about before, one of the benefits of diversification is reducing risk and volatility in a portfolio and reducing risk and volatility makes it easier for investors to stay the course. Once again, the best investment is the one you can stick with.
Before we go any further, it's important to acknowledge that 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 investment behavior. However, both of these studies and their methodologies continue to receive criticism, with some finance experts suggesting that the gap does not exist or it's much smaller than these studies lead you to believe.
Now, I'm not going to dig into that here today. You can Google around if you want to read more of some of the criticism. But my good friend and colleague Colin Roche had one of the better rebuttals to this criticism a couple of years ago 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, 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 in a mind mockingly 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
that these investors make pretty bad decisions consistently. Morningstar acknowledged in this year's report that investors have made some small strides over the years, but there is, of course, always room for improvement. As a starting point, there are three things an investor can do to improve or narrow their own behavior gap and capture more of the returns delivered by the funds that they're investing in.
1. Keep it simple and stick with plain vanilla broadly diversified funds or asset allocation funds. As Morningstar put it, allocation funds help mitigate the risk of mental accounting mistakes that investors are prone to, such as buying more of a high-performing strategy and selling a lagging one, when they should be doing the opposite. 2. Avoid exotic, concentrated funds, as well as funds with higher volatility.
especially funds with higher volatility that don't match up with your stated goals. Most investors will be better off over long periods of time maintaining proper diversification, matching the risk and volatility of their investments with their goals and keeping investment costs low, all of which would lead them away from funds that have historically had the highest behavior gap.
And then finally, number three, perfect is the enemy of good. Or said another way, good beats perfect. As Morningstar concludes in their study, evidence suggests that investors have had greater success favoring simpler solutions, solutions they understand and can stick with over long periods of time.
Here's Carl Richards in his book, quote,
Why the disappointment? You've probably guessed the answer already. We often resist simple solutions because they require us to change our behavior. On that note, if you think you would benefit from professional help and you want to learn more about how my firm and I implement simple, low-cost investment portfolios to help our clients navigate the complexities of retirement, please reach out to us.
We remain highly specialized and we're dedicated to helping people over age 50 who are retired or close to it, reduce their tax bill and turn their nest egg into a retirement paycheck. And to help you evaluate our firm and others that you might be interviewing, we're currently offering a free retirement and tax analysis.
There's no catch here. We'll answer all your big retirement questions, produce a custom tax analysis, and provide actionable recommendations, allowing you to see how we think, how we work, and exactly how our firm can help before paying us a single dollar.
To learn more, just go to freeretirementassessment.com or if easier, you can click the link in today's episode description right there in your podcast app. And as always, if we don't have the right expertise to help, we will happily help you find a financial professional who does. After all, you wouldn't go to a heart surgeon if you needed knee surgery.
I hope you enjoyed today's episode. Thank you, as always, for listening. And I'll see you back here next week.
