Investors should fear themselves

Research indicates closing the behaviour gap – the tendency for investors to underperform the funds they are invested in – is crucial to long-term returns

Are you concerned about the slowing Chinese economy? Do you worry that valuations seem high, after six years of strong gains for global stock markets? Maybe you are fearful that you have picked the wrong funds, or that an incompetent fund manager might cost you dearly in coming years?

Different investors worry about different factors, but the biggest danger, perhaps, lies closer to home: you.

A mountain of research confirms investors are their own worst enemy, as evidenced by the so-called behaviour gap: the tendency for investors to underperform the funds they are invested in.

There are many ways this can happen. Let’s say you have €100,000 to invest, but you’re not sure when and where you should invest. Accordingly, you invest €50,000 in a fund. It gets off to a flying start, soaring 20 per cent in just six months, so you invest the remaining €50,000.


However, the markets retreat over the next six months, falling 10 per cent. Over the course of the year, the fund has gained 8 per cent, but your investment has fallen in value by 1 per cent. Your initial €50,000 investment, like the fund itself, gained 8 per cent, becoming €54,000; the second €50,000 was invested for only the second half of the year, during which time the market fell 10 per cent, so it is now worth €45,000. Accordingly, your €100,000 investment is worth €99,000, despite the fact your fund enjoyed a decent 8 per cent gain.

The above example is hypothetical, and a sceptic might point to other possible scenarios whereby an investor outperforms the fund he is invested in.

However, this rarely happens; investors systematically underperform, for all kinds of reasons.

Buy high, sell low

The obvious one is many put their money to work in bullish climes, only to get spooked when things get ugly – that is, they buy high and sell low.

Carl Richards, the US financial adviser who coined the term "behaviour gap", says prior to January 2000, the record net inflow into equity funds was $29 billion.

That January, inflows hit $46 billion: three times their monthly average. Another $54 billion followed in February, with $39 billion coming in March – the peak of the dotcom bubble, when equity valuations hit unprecedented levels.

The opposite occurs at the bottom of equity market cycles, says Richards, noting that October 2002 was the first time in history in which net outflows occurred for five consecutive months. Markets bottomed that month; by then, the S&P had halved, and the Nasdaq had fallen 78 per cent.

Bear market

Investors were even more pessimistic in March 2009, at the bottom of the worst bear market since the 1930s; bearish sentiment, as measured by the American Association of Individual Investors survey, hit a record high of 70 per cent that month.

Most investors don't buy at the top and sell at the bottom, but their market-timing efforts do cost them. John Bogle, founder of fund group Vanguard, has estimated that after costs, the average fund returned 10 per cent annually between 1980-2005. The average fund investor, however, earned annual returns of 7.3 per cent.

One major study, What Are Stock Investors' Actual Historical Returns?, found that between 1926-2002, the average US investor underperformed the stock market by 1.3 percentage points annually.

The average Nasdaq investor, it found, underperformed the index by 5.3 percentage points annually between 1973-2002.

Between 1973-2004, the average investor in 19 major stock markets underperformed by an average of 1.5 percentage points annually. Actual investor returns, the study concluded, are “systematically lower than buy-and-hold returns for nearly all international stock markets”.

Various other studies have found investors lag the funds they are invested in by between 1-2 percentage points annually. Over time, that adds up; a €10,000 investment compounding at 7 per cent annually over 30 years will grow to €76,122, compared to €43,219 for an investment returning 5 per cent annually.

Some investors will do worse than others. Vanguard has released data showing the vast majority of investors in its index funds made no portfolio changes during market panics in 2008 and 2011. Research indicates investors in passive funds nevertheless underperform the funds themselves, but the behaviour gap is much more pronounced among investors who gravitate to more volatile funds or sectors.

The tech-heavy Nasdaq, for example, has always been a volatile index; judging by the aforementioned statistics regarding Nasdaq investors, this volatility can cause investors to lose their heads. Investors in exchange-traded funds (ETFs) also lose out, according to John Bogle. He analysed 79 ETFs, and found 68 had investor returns that were short of the returns earned by the funds themselves. Again, the behaviour gap was most noticeable in volatile sectors.


Ironically, even investors who select the best funds also doom themselves by their actions. Countless studies show a value-investing approach – essentially, buying cheap stocks – beats the market over time.

However, investment firm Research Affiliates found the average value-investor does not get to enjoy these excellent returns. It’s the usual problem, with investors “allocating away from value funds after a period of underperformance and towards them after a period of outperformance”.

This was especially evident in the late 1990s, when investors deserted value-managers who refused to invest in high-flying technology stocks. Value-investing firms enjoyed huge outperformance after the dotcom bubble finally burst, but many clients had left by then.

The conclusion of Research Affiliates is blunt: “Investors are so spectacularly bad at market timing that they routinely wipe out all, or more than all, of the outperformance produced by value-oriented managers”.

Warren Buffett famously advises investors to be greedy when others are fearful and fearful when others are greedy, but we appear hardwired to do the opposite.

Carl Richards' advice is simple: buy index funds, diversify, add bonds to your portfolio, and rebalance. Above all, be aware of the behaviour gap, and remember that investing "is about behaviour, not skill." Boosting returns: Is a good financial adviser worth it? The oft-cited annual report by Boston firm Dalbar into average investor returns would indicate that a good financial adviser can significantly boost investor returns.

According to Dalbar, the average fund investor has earned an average of 5.19 per cent over the past 20 years, compared to 9.85 per cent for the S&P 500.

Some caveats, however. Firstly, while countless studies confirm the average investor underperforms the average investment, no other study indicates the behaviour gap to be as large as that suggested by Dalbar. Critics say Dalbar’s methodology is flawed, resulting in an exaggerated assessment of investor underperformance.

Secondly, ordinary investors are not the only ones to underperform. One study found pension plans and other apparently sophisticated investors badly underperform the hedge funds they invest in; poor timing costs them at least 3 percentage points annually, the study found.

Thirdly, it’s true that ordinary investors chase returns, switching their money into ‘hot’ funds instead of accepting that even the best funds and strategies will suffer periods of underperformance. However, it’s also true that most of the money in funds “is advised”, to quote Carl Richards; “it gets there because an adviser put it there”.

In other words, the behaviour gap is substantial but not as large as some advisers might suggest. A good adviser may well be able to reduce that gap; a less-informed adviser, alas, may widen it.