Many studies, including the widely cited DALBAR Quantitative Analysis of Investor Behavior, have demonstrated that investors underperform their investments by a wide margin. The difference between fund returns and investor returns is called the behavioural gap and it exists because investors tend to chase investments that are posting strong returns and avoid poorly performing ones. In a recent blog post, Larry Swedroe referred to a Morningstar study that found US investors underperformed their mutual fund holdings by 2.0 percent over a 1-year period and 1.3 percent over a 3-year period ending December 2010. (Hat tip to Steadyhand blog’s Mind the Gap post).

In The Little Book of Common Sense Investing (read my review here), John Bogle points out that over a 25-year period, an equity index fund earned an annual return of 12.3 percent. The average equity mutual fund earned an annual return of 10.0 percent due to fund fees and expenses. But the average mutual fund investor earned only 7.3 percent – a gap of 2.7 percent each and every year for a quarter century. Interestingly, passive investors also underperformed their investments by earning a return of 10.8 percent, a shortfall of 1.5 percent.

Bogle, a long-time critic of exchange-traded funds, found shocking levels of investor underperformance in these investment vehicles. In the Little Book, he cites the record of 20 best performing ETFs over a four year period: the average shortfall was 5 percent a year. The results were consistent in an updated report that showed an average gap of 4.5% over a 5-year period. Due to the ease of trading and the breadth of choice available, investors are speculating with ETFs instead of investing in them for the long-term.

This article has 7 comments

  1. It’s amazing how study after study comes out showing that you had better be either a computer algorithm genius, or one of the crazy smart hedgefund managers if you are going to “beat the street.” If you’re not one of these things simply stick with index funds and ETFs. So simple…

    • @My University Money: Like Canadian Couch Potato says, many of these crazy smart hedge fund managers go belly up too. Maybe they are the smart ones because they simply then start another hedge fund and if that goes belly up, they start another one and so on…

      @cynical investor: Yep, I owned many of the individual stocks that either went belly up or are permanently damaged. Nokia, AIG, Yellow Media, E*Trade etc. come to mind. Yes, I’m thankful I became an indexed investor too!

  2. @My University Money: Have a look at the books “When Genius Failed” by Roger Lowenstein and “The Quants” by Scott Patterson. The crazy smart hedge fund managers usually end up in the toilet, too. :)

  3. Somehow related: with the funds I had I didn’t lose more money than the market and made it back when the market rebounded. With individual investments I have lost more than the market and with most of them I never recovered the loss, not to mention I had a few that went bankrupt on me.

  4. I am skeptical of these sorts of studies.

    There are two sides to every trade. Who is taking the “smart” side of all of these trades? The money does not just evaporate.

    I have yet to see any evidence about who is receiving the upside from this “behavioural gap”. The studies do not point to any large group in the market consistently making above-market rates of return. Somebody has to be buying low and selling high. It is a zero-sum game (after fees).

    Show me the money.

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