Have you ever invested in a fund that shows an amazing return, but your investment in that fund does not match up?
A decade ago, Carl Richards, released the book The Behaviour Gap: Simple Ways to Stop Doing Dumb Things with Money. He used the term “behavior gap" to describe the difference between the return an investment organically produces over a fixed time frame, and the return an investor in that very investment actually earns. The result is usually not in the investor’s favour.
The behavior gap is the difference between the rate of return an investment produces in a certain amount of time, and the rate of return that investors actually earn on that investment. Investment returns and investor returns are almost always different.
Investment returns that you see in the media or in marketing material are based on the assumption that you invest a lump sum at the beginning of the period, and then you leave it alone. You do not buy or sell. You do not change your mind and trade to another fund. You just buy once and hold.
Investor returns measure your real-life return. The return you earn as you buy and sell your investments, or switch from one investment to another in your search for the next hot thing.
The gap could be causes by various reasons, or a confluence of them: Timing the market, buying (or selling) on the basis of recent performance, chasing after a fad, or just deciding to leave the market when it's temporarily down. All these decisions can be destructive to your portfolio.
How can we bridge this gap between the fund return and investor return?
Morningstar’s fund research team has done some research on this subject. Here are some lessons we can glean from their findings.
RESEARCH: They looked at the 3-year return of a pharma fund as of April 2022. It stood at 23%, but the average return of investors was 6% lower. Pharma Funds received significant inflows since 2020 as this sector performed well when the pandemic hit. Investors chased this recent performance and piled into these funds. Unfortunately, they are often late to enter a theme and sell when they don’t earn returns.
- Have an investment thesis when buying. Why are you buying it? How does it fit into your portfolio? If it is a sector/thematic fund, why are you buying it now, why do you believe the sector/theme will do well, and when do you plan to exit? Timing the exit is very difficult in such cases.
RESEARCH: They did a study spanning 10 years, to understand how many months of performance contributed to a fund’s overall outperformance over the benchmark. They found that only six months contributed to a fund’s entire outperformance over the benchmark. If you, as an investor, missed being invested over those six months, you would have underperformed the benchmark.
- Stop timing your investments. It is easy to say that I will enter in a downturn and exit at the top. It doesn’t pan out so easily in reality. You can’t time your investment as no one can predict when those months of outperformance would strike. When you chase trends and move in and out of funds, you miss out on those critical months.
- Investors would do significantly better by investing regular monthly amounts over various market cycles rather than one-off lump sums. When you automate your investment, the opportunities to act out of emotion diminish.
RESEARCH: Another example. The best-performing equity fund delivered 40% over the last three-year period as of April 2022. An average investor in this fund made only 20%, so the gap is half. Around 75% of inflows into this fund came only in the last one year.
- It is also futile to chase the latest performers.
- No fund performs great year after year after year. Funds will go through cycle of outperformance and underperformance based on the style and the strategy of the fund.
- It is futile to exit when the fund is down. Write down your goals and the investments needed to meet them. When you look at your long-term goals, you are more likely to leave your investments alone because you deep down do know for a fact that markets go through cycles and it will bounce back.
This is important
What leads to the behaviour gap is not that you have chosen the wrong investment. It is your behaviour driven by emotion or latest performance.
You’re more likely to see the value of your investments rise over an extended period if you leave them alone. Stop chasing latest performers. Stop continually switching your holdings to try and beat the market.
Investor behavior matters a lot, probably even more than skill.
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