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.