Trending
Every year Morningstar puts out their Mind the Gap research that quantifies how much investors underperform both an index and the very investments they are invested in. This post shares some of the most interesting findings and suggests some ways advisors can help their clients reduce that performance gap.
Overview of Main Findings
Morningstar estimates that the average dollar invested in US mutual funds and exchange traded funds earned approximately 1.1% less than the very funds they were invested in. This underperformance is not unique. There is a long history of investors underperforming both an index and their own investments.
The reason they underperform is due to the timing of purchases and sales of the investments. We know that investors are prone to buy after they see strong performance and sell after experiencing a period of poor performance. It’s not just the performance alone, but also the accompanying news stories that are so powerful. When things are going well, the news and outlook tend to be positive. And when markets sell off, the news turns negative. Fear is driving these decisions, whether that be the fear of missing out or the fear of losing more.
Of course, investors won’t say the are buying our selling out of fear. Instead, the brain will do what it is so good at doing. Rationalizing our decisions. They will likely point to a more positive outlook and feeling more confident to invest…as if the future were more certain. And when they are selling, they will point to negative outlooks and believe it is irresponsible to remain invested when things are about to get worse.
Morningstar noted that many investors struggled to invest well during the COVID Crash of 2020. They found investors adding money in late 2019 and early 2020, only to withdraw nearly half a trillion dollars as markets fell. Whoops!
Differences in Behavior Gap
Not every investment category had the same behavior gap. Perhaps not surprising, the category “Allocation” had the smallest behavior gap (smaller gap than bonds), while “Sector Equity” had the highest. What is a principal difference between Allocation and Sector Equity? Diversification, and lack thereof. It was the volatility each investment experienced.
This tells us that price fluctuations provide stimuli for poor investment decision-making. And since price fluctuations are an inherent part of the markets, we need to realize our clients are almost always tempted to make a bad investment decision.
Mutual Funds vs. ETF – Behavior Gap
Morningstar looked at money movement among both mutual funds and ETFs. Up until now, the results included them grouped together. But the results weren’t the same. In 7 of 8 investment categories, ETFs had a larger behavior gap than mutual funds in the same asset class. Any idea as to why? If the asset class was the same, what could influence investors in ETFs to have a larger behavior gap?
Given what we know about how price fluctuation influences investor behavior, it could have to do with the fact that ETFs trade during the day, so investors can witness all the price movement, rather than just an updated price at the end of the day. I just find it interesting that if all else is equal (portfolio, cost, tax consequences), mutual funds may be better off than ETFs for investors sensitive to price movement.
Selling During a Bull Market
Morningstar also found that despite the strong bull market from 2014 – 2023, investors were net sellers. They didn’t just sell a little. They sold a lot. Investors withdrew $1.9 trillion during that time. Why would investors be net sellers during a bull market?
Morningstar doesn’t address this, but since we know a thing or two about psychology, we can give it a shot. The Global Financial Crisis was brutal – not just with the awful performance during those years, but the psychological scars after. It is quite possible that investors were fearful for the next shoe to drop. They were quick to sell and capture their gains, lest the market turn over and they would lose it again. This is a very plausible explanation and is actually one of the fruits of loss aversion.
Largest Fund Categories – Behavior Gap
The smallest behavior gap among the largest fund categories occurred in Large Blend and Foreign Large Blend. Intermediate bonds, emerging markets, large growth, and large value all shared the highest behavior gap.
Isn’t it interesting that Large Blend was had a small behavior gap, but its components, Large Growth and Large Value had the largest of the group? This further reinforces that a diversified approach that minimizes fluctuations results in a smaller behavior gap.
We can take this one step further to consider SMA vs. UMA. For transparency, it is nice to break things up for clients by using a SMA strategy. They can clearly see everything they own by style and/or philosophy. It can be easy to change out managers as you see fit. However, the results from Mind the Gap demonstrate that a UMA could be preferable because clients would just see one return blended, rather than the individual returns and fluctuations of separate accounts.
Active vs. Passive – Behavior Gap
There is no discernible difference between index funds (passive) and actively managed investments. Some were better than others in different categories, but nothing conclusive can be drawn.
This further confirms that investor performance has little to do with whether the investment they own is passive or active. That is really the decision of the advisor in line with the client’s objectives. Of course, all things being equal, the lowest cost and tax efficient option is better.
Helping Clients Behave Better
You can help clients from a psychological aspect and you can help them through the portfolio recommendation. The best behavioral coaching does both – it is a comprehensive approach to working with clients. However, this post only deals with the portfolio side of things.
The research is clear that whatever you can do from a portfolio construction standpoint to lessen the fluctuations in portfolio value(s), the better your client is likely to behave. If they don’t experience wild swings, they will be less triggered by their innate biases.
Related: Your Investments Returned 12%—But Are You Truly Happy?