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Personal Finance

How to earn 1.7% more a year than the average investor

Changing your investment approach can make a significant difference in returns over the long-term. 


"The investor's chief problem—and even his worst enemy—is likely to be himself."

– Ben Graham

Investors are fixated on returns. And this isn’t a surprise. Afterall the whole reason we sacrifice consumption to save and invest is to earn a return. We want our money to grow so there is more of it to spend in the future.

But the fixation on returns has a downside. Many investors use performance as the deciding factor when selecting investments. This flies in the face of the oldest adage in investing – buy low and sell high. Yet we continue to chase performance.

There is a lot of commentary around poor investor behaviour. It is mostly theoretical in nature. But each year Morningstar quantifies the impact of poor investor behaviour. Our annual Mind the Gap study was just released, and investors are costing themselves 1.7% a year in returns through poor behaviour.

The impact of 1.7% a year in lost returns

 

Investing $1000 and earning a return of 7% a year for 30 years results in $1.169m. Not too bad. Earn an 8.7% return and the total is $1.607m. Even better.

Small differences in returns can have a profound impact over the long-term on the total wealth generated from investing. And 1.7% a year is not a small difference. Over the past 30 years Australian shares have delivered 9.8% per annum. The impact of poor investor behaviour represents 17.34% of this return.

Morningstar’s Mind the Gap study

 

The study estimates the return of the average dollar invested in funds and ETFs (that is, “Investor Return”) and compares it with the average fund’s total return. Any difference is attributable to the timing of investors’ purchases and sales. The smaller the gap, the more investors captured their funds’ total returns and vice versa.

In this year’s study, we found the average dollar invested in funds earned a 6% annual return over the 10 years ended Dec. 31, 2022, while the average fund gained about 7.7% per year over that same span, for a gap of about 1.7% annually.

That gap is similar to what we’ve found when estimating the dollar-weighted return gap for the 10-year periods ended December 2021 (-1.7% gap), 2020 (-1.7%), 2019 (-1.5%), and 2018 (-1.6%). This suggests that timing costs are a persistent drag on the returns investors earn.

There are factors that influence how big the gap is between investment returns and investor returns. Investors are more likely to mistime investments in highly volatile funds than less-volatile funds. This makes intuitive sense. Investors are using price changes as signalling mechanisms to make changes to their portfolio. This is at the heart of why these poor decisions are made.

Poor timing decisions in practice

 

We invest based on our anticipation of the future. Expectations of the future are therefore baked into security prices. If investors have high expectations for the future prospects of a company the shares will trade at a higher valuation. That isn’t necessarily a bad thing – as long as those expectations are met.

For example, when the economy is strong and growing it is good for company earnings. But shares often rally significantly prior to the economy turning. This can create cognitive dissonance for investors. The economic environment experienced on a day to day basis is very different than the performance of the stock market which is already looking down the road to an economic recovery. This is very challenging for investors.

In webinars I often use the global financial crisis as an example. The American stock market rally began ~6 months before unemployment peaked in the US. And it is important to remember that it would have required clairvoyance at the time to know this actually represented the peak. Investors who waited for clear signs of an improving economy missed out on significant gains that grew into one of the greatest bull markets in history.

In retrospect it seemed obvious that it was a good time to invest. Market commentators will look back to history and say that shares were cheap and point out the rally that followed as justification for their view that it was an obvious time to invest. We take comfort in the logic of this argument and assume that we would have acted rationally and purchased shares at the bottom of the market.

But at the time shares were not cheap because earnings had fallen in response to the economic crisis. What made them cheap in retrospect was the economic revival and the resulting earnings recovery. And there are countless examples when the market has rallied on hopes of a recovery which didn’t come to fruition. The classic bear market rally.

The larger point is that timing the market is hard. Expectations are baked into prices which means that once there is more clarity on the certainty of an outcome it is often too late. Timing the market means anticipating future events before other investors. It also means getting the call right. That can be a lonely and intellectually challenging exercise. Because everyone else is doing and saying the opposite. It is hard to go against the crowd.

The timing decisions that cause the gap between investment returns and investor returns come from chasing asset classes, sectors and individual funds and ETFs after their periods of outperformance. Investors believe they are onto a sure thing because the investment narrative is compelling and the feedback loop of recent outperformance reinforces this optimism. I’ve written about this in response to the ongoing Lithium narrative.

Chasing performance is not simply looking at what performed best and investing in it. It is operating under the illusion that investment success stems from being nimble and responding to what seem like can’t miss opportunities.

Who is impacted by the gap between investor returns and investment returns?

 

The short answer is everyone. The study looked at funds and ETFs because the data on investor flows and the underlying returns of the individual investment vehicles is available. But investors that focus on individual shares have the same issue.

This impacts both active and passive investors. Many people assume that investing in passive investment vehicles that track a well-known index means that they are insulated from the behavioural risk that leads to the gap. That is not true. It is how you use these passive vehicles.

Periodically selling one passive ETF and buying another is an active investment decision. Making adjustments to how much is saved and invested in a passive vehicle based on market conditions is making an active decision.

How to limit or eliminate the timing gap in returns

 

This is simple. Become a buy and hold investor and accept that there will inevitably be periods of outperformance and underperformance. The University of California performed a famous study of US brokerage accounts. The study looked at times when investors sold one investment to purchase another. The investment sold outperformed the one that was purchased by an average of 3.32% after 504 trading days.

Given Morningstar’s Mind the Gap study and the University of California study, investors need to assume that each change in a portfolio is on average a bad idea. That doesn’t mean that changes shouldn’t ever be made. What it does mean is that an investor’s default mindset should be buy and hold and that making changes to a portfolio should be based on a long-term strategy designed to achieve a specific investor goal. Our Investing Compass podcast episode covers the approach

Investors should put as much structure around decision making as possible. That means defining goals and establishing a personal investment policy statement that outlines an investment strategy, asset allocation target and criteria for picking individual investments. Make sure this is written down.

It also helps to put speed bumps into decision-making. The thought of outsized returns from an investment with a compelling narrative can create a euphoric sensation that doesn’t differ too much from the thrill of sitting at a blackjack table and watching the dealer laying cards on the table. This feeling can be tempered by separating an idea and any subsequent action. Give yourself a 24-hour period of reflection to dwell on why you may be wrong. Have a conversation with a mate about why this is a good idea that will help you achieve your goals and why it may not work out.

The impact of poor investor behaviour is a risk to your financial future. But it is also an opportunity. Knowing that most investors – individuals and professionals – succumb to return reducing behaviour provides a surefire way to be an above average investor. It doesn’t take a fancy degree or more intelligence. All it takes is making less mistakes and eliminating the gap between investment returns and investor returns.

Share any thoughts with mark.lamonica1@morningstar.com. The Mind the Gap study can be accessed here.



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