Why Investors Underperform Every Year and How to Improve Returns - Episode 39
Today I’m sharing a recent Morningstar study about why investors underperform every year and how to improve your returns. I will also tie in how advisors can add value.
Listen to Episode 39 Here:
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Mind the Gap
A “Mind the Gap” study of investor returns by Morningstar showed a considerable gap between total fund returns and what investors earn.
For the 10-year period that ended December 31, 2020, investors earned about 7.7% per year on the money they invested in mutual funds and exchange-traded funds (ETFs).
The funds themselves earned 9.4%, which is about 1.7% more than what investors earned, during the same time period.
This means investors are losing almost one-sixth of their potential return every year. That can add up to a substantial amount over a 10-year period!
Morningstar has conducted this study for the past 5 years over a rolling 10-year period with the annual return gap falling between 1.6 and 1.8% annually.
How do asset classes compare?
The study also reviewed various asset classes. Higher volatility investments showed a higher return gap.
Investors of more volatile funds like alternative funds and sector equity funds experienced a larger return gap of 4.3% and 4%, respectively.
While investors of less volatile funds like U.S. equity funds and taxable bond funds experienced a smaller return gap of 1.2% and 1.1%, respectively.
Asset allocation funds, like target date funds, have an even smaller return gap at 0.7%. This would suggest that their built-in diversification helped investors stay committed to the long term.
Why does this return gap exist?
This gap between investor returns and total returns is often referred to as the behavior gap.
The behavior gap is caused by poorly-timed purchases and sales. The more you trade, the more likely you are to underperform.
The study noted that systematic investing improves investors’ returns over time when compared to active trading. This is referred to as dollar-cost averaging.
By using a scenario where the investor made monthly contributions of the same amount over the 10-year period, the behavior gap was reduced in most asset categories.
However, dollar-cost averaging is not usually as effective as using a lump-sum of money to buy and hold investments. Since returns tend to be positive over time, when your money is invested longer, you can take full advantage of those positive returns.
It is important to note that the annual expense ratio of funds also plays a role in the return gap. However, it was not consistent across asset classes that higher fees equal a higher return gap.
How to improve your returns
Morningstar shared 4 things that retirement investors can do to improve their returns as a result of this recent Mind the Gap study.
- Keep it simple and stick with broadly diversified funds.
- Automate routine tasks like setting your asset allocation targets and periodically rebalancing.
- Avoid narrowly concentrated funds as well as those with higher volatility.
- Embrace techniques that put investment decisions on autopilot, like dollar-cost averaging.
These suggestions also tie into where an advisor can really add value for clients.
How Advisors Add Value
According to Vanguard, advisors add “about 3%” per year in value to investors.
The Vanguard Advisor’s Alpha framework has outlined how this value is added through relationship-oriented services such as wealth management and behavioral coaching, and as you know, we believe we add a great deal of value with tax planning and limiting lifetime tax liability at Eagle Ridge Wealth Advisors.
They also say that for some clients, you may offer much more than 3 percentage points of increased returns and maybe less for others. This return is not added over a specific time frame but varies each year and according to client circumstances. It can be added quickly and dramatically, especially during periods of market decline or euphoria. It may be provided slowly. It will not appear on a client’s quarterly statement, but it is real nonetheless.
This value is added by establishing suitable asset allocation with cost-effective implementation, asset location, and a focus on total-return versus income investing. Other ways to add value include proper rebalancing, proper spending strategies, and most importantly, behavioral coaching.
Choosing an investment plan that you can stick with and that matches up with your goals and your risk tolerance will produce the best results for you over a long period of time.
Also, having a professional help you down the proverbial mountain in retirement is highly recommended. After all, most people get hurt coming down the mountain as opposed to during the ascent.