Each year, Morningstar publishes a study called Mind the Gap, which measures the returns that investment funds generate vs. the returns that investors actually earn. The study offers a powerful reminder: even when we choose great investments, our behavior—when we buy and sell—can significantly impact our outcomes.
Over the last 10 years, U.S. mutual funds and ETFs delivered an average annual return of 7.3% net of fees. Yet, the average investor earned just 6.3% – a gap of 1.1% per year. That may sound small, but over a decade, it implies a drag of 15%.
Why does this happen? The gap is mainly due to timing: investors often add money after markets rise, or strategies outperform, and pull money out after declines or poor performance, aka “buy high, sell low”. A striking example occurred in 2020: many investors withdrew funds after the COVID-19 crash (participating in most of the drop). They did not add back until after the rebound was confirmed (missing most of the recovery). That year, investors underperformed their funds by 2%, vs ~1% on average. And in no year in the last decade did investors fare better than their funds, suggesting that investor trading consistently leads to lower-than-average results.
The study also found that the gap varies by strategy. Investors in broadly diversified allocation strategies like balanced and multi-asset funds fared best, with a gap of just 0.4%. Meanwhile, those in sector-specific and thematic funds, which are more volatile, saw gaps as wide as 2.6%. Interestingly, active fund investors fared worse than those in passive funds (1.2% vs 0.8% gap), despite ostensibly choosing active strategies to outsource trading.
So, what can you do to avoid falling into this trap?
- Stay the Course: The most effective way to capture the full potential return is to remain invested. Market timing is notoriously difficult, and reacting emotionally to short-term volatility often leads to poor decisions.
- Diversify: Allocations across multiple asset classes reduce the need for frequent trading as some parts are always performing. Diversified strategies help investors stay disciplined and invested through market cycles.
- Avoid Chasing Performance: Don’t jump into strategies just because they’ve recently done well. Past performance is not a reliable predictor of future returns, and chasing “hot” funds or themes often leads to disappointment.
- Dollar-Cost Average: Investing regularly can help smooth out the impact of market volatility and reduce the temptation to time the market.
- Understand Your Investments and Yourself: Strategies with higher volatility tend to have larger gaps. So, if you are likely to react to a strategy’s high volatility, it might not be the right investment.
In short, the key to better investment outcomes isn’t just picking the right investments – it’s using them wisely. By staying disciplined, diversified, and patient, you can close the gap and keep more of what your investments earn.
DISCLOSURES
The information provided is for educational purposes only. The views expressed here are those of the author and may not represent the views of Leo Wealth. Neither Leo Wealth nor the author makes any warranty or representation as to this information’s accuracy, completeness, or reliability. Please be advised that this content may contain errors, is subject to revision at all times, and should not be relied upon for any purpose. Under no circumstances shall Leo Wealth be liable to you or anyone else for damage stemming from the use or misuse of this information. Neither Leo Wealth nor the author offers legal or tax advice. Please consult the appropriate professional regarding your individual circumstance. Past performance is no guarantee of future results.
This material represents an assessment of the market and economic environment at a specific point in time. It is not intended to be a forecast of future events or a guarantee of future results.
Mutual Funds and Exchange Traded Funds (ETF’s) are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from the Fund Company or your financial professional. Be sure to read the prospectus carefully before deciding whether to invest. An investment in the Fund involves risk, including possible loss of principal.
Neither Asset Allocation nor Diversification guarantee a profit or protect against a loss in a declining market. They are methods used to help manage investment risk.
Dollar cost averaging may help reduce per share cost through continuous investment in securities regardless of fluctuating prices and does not guarantee profitability nor can it protect from loss in a declining market. The investor should consider his/her ability to continue investing through periods of low price levels.
