Investors Are Missing Out on Nearly 16% of Investment Returns

In a recent study published by the investment research company Morningstar, they estimate that the average dollar invested in funds, such as mutual funds and ETFs, by individual investors over the 10 years ending December 31, 2023, earned a 1.1% lower rate of return per year than the actual investments they were invested in, which resulted in missing out on nearly 16% of the investment's actual returns each year. And, no, this didn't result from investment fees. Morningstar updates this data annually as part of their Mind the Gap study. Today, I want to break that down, why this is happening, and what it means for investors.

Welcome to Retired-ish. I'm your host, Cameron Valadez. And today, I wanna dive right into one of the most enlightening studies in investing, known as the Mind the Gap study conducted annually by Morningstar. In a nutshell, this research shines a light on how investor returns compare to the actual returns of the exact investments they invest in, which are two very different things.

One is your personal return, which can be affected by your personal actions, such as buying and selling, and the timing of those actions. That's the investor return. The other is the return on the investment itself without intervention. This study compares the averages of these two returns over the same time period to shed light on the effect investors have on their own investing experience—really powerful stuff. If you want to dive deeper into this study and look at some of the visuals and charts Morningstar provides, you can access the links to the study in today's episode show notes by clicking the link on your podcast app or just going to retiredishpodcast.com/56. Okay. Let's dive straight into this.

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To illustrate what this study is showing in layman's terms, imagine you're a do-it-yourself investor invested in some sort of mutual fund, index fund, or ETFs, which stands for exchange-traded funds, that returned on average 7.3% over the last 10 years per the investment website or prospectus. But when you review your actual account statements over the years, whether that be a brokerage account, a 401(k), or the like, you find your average returns short by over 1% without including any sort of possible account fees or costs. You might be left wondering why that is. That's what this study helps us understand. The gap they are referring to in the phrase Mind the Gap is the gap between investment returns and the investor returns. The first thing to understand before we dive into this a little bit further is that a particular fund's total return assumes an initial lump sum purchase that is held until the end of the given time frame that's being reported. However, this isn't the experience most investors will actually have. Typically, investors initially purchase a fund or series of funds when building a portfolio.

[00:03:59]:
Then, they may continue to add to it and buy more of a particular set of funds. They will periodically take various amounts of money back out of the fund or the portfolio via withdrawals or simply buy and sell funds at various times within the investment account. Because of this reality, your returns won't necessarily be the same as the returns the actual investment itself can produce. Instead, it will be whatever your average dollar earned given the timing and amount of those buys and sells or those purchases and withdrawals. As an important side note, it's also critical to know that this study looks at the averages. So, in order to end up at these averages, there are usually outliers on both sides of the equation. This means that some investors can have a much bigger return gap compared to the average returns that we will be discussing provided by this study. And as I mentioned previously, Morningstar has been producing this study for several years now.

One of the most interesting things they found was that the most recent studies results are actually quite in line with previous studies going back to 2018, even given the increased political and economic uncertainty in the past couple of years, including the pandemic. The return gaps from the previous studies dating back to 2018 range between a 1.1% to 1.7% lower average rate of return for investors.

To me, this indicates that, historically, things haven't really changed when it comes to investor tendencies to react to unpredictable and scary news cycles, chase the most recent successful investing fads, overconfidence in their own abilities to invest, and reactions to sudden market movements or trying to time the markets in some fashion. These investing behaviors are fairly well studied and understood, especially among financial planning practitioners. In fact, we have talked about these tendencies many times before on this show.

These natural behaviors have been around for centuries, and when it comes to investing, as the renowned financial author Morgan Housel, puts it, same as ever. From this study, we can actually see the real effects of some of these behaviors over time by reading between the lines. For instance, notably, Morningstar saw the gap vary widely depending on the type of asset class that was being invested in.

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To give you an example, investing in an allocation type of mutual fund, which is similar to a target date retirement fund usually found in 401(k) plans, produced many different gaps in returns versus a specific sector-based fund, such as a tech sector mutual fund, which would invest primarily in stocks in just the technology sector. They show that the average dollar invested in allocation funds, which essentially adjusts the investment allocation within the fund for the investor or on their behalf, those only had a .4% lower average return gap. Said differently, these funds returned 6.3% on average, while investors saw 5.9% on average over the same 10-year time period.

On the other hand, when it came to investing in specific sectors, the gap widened substantially. Investors missed out on 2.6% in average annual returns on the average dollar invested. That may not sound like much, but when compounded over 10 years, it can be an absolutely astounding amount of money. The actual sector investment returns in the study produced a 9.6% average rate of return over the same 10 years. While the study looked at a total of about eight different asset classes, I want to focus on these two because they tell us a story and teach an important lesson.

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It is highly likely that the reason investors received most of the actual returns of those allocation types of funds is because of how most investors purchase these funds. As I mentioned, although these types of investments are available pretty much anywhere, most investors in these allocation funds are participants in employer group retirement plans, such as 401(k)'s, 457 plans, 403B plans, and so on and so forth.

Most people who are participating in these plans like to “set it and forget it.” They have an amount deducted from their paycheck, consistently buying into the market or that fund each time they get paid and not fiddling too much with their investment allocation or choices. These plans usually have fund options that automatically allocate you based on the length of time before you expect to reach your retirement goal. As I mentioned previously, these are typically referred to as target-date retirement funds. Because there is little interference and often less random buy-sell activity by these investors in their working years, they seem to be closer to receiving the actual returns of the given funds. On the other hand, those who are actively choosing a specific sector, such as the tech sector or energy sector, for example, are typically engaging in some form of market timing.

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It looks like this. Your buddy works for a big gold mining company and mentions that business has never been better. So you decide to go buy a mutual fund or ETF that invests in stocks of gold mining companies only. You are, in a sense, speculating that this industry or sector will outperform all of the other investment options available to you. Of course, whether or not you actually get the investment returns you expect will depend on a variety of different things.

Whether or not the investment performs well in the short term and or the long term depends on when you're going to use that money, how long you hold the investment before you sell it, or the timing of when you sell it, and how often you buy more of the investment if you do at all, and how it performs following each purchase. I've said many times before on the podcast that no one can consistently time markets or sectors, not even the most highly regarded professionals. There are just too many variables.

In addition, these types of investments are much more volatile than something like an allocation fund, meaning their ups and downs can be more drastic due to being less diversified and concentrated in one particular area of the overall market. So, the statistics that this study shows us line up perfectly with this concept that investors continue to suffer from poor investment behaviors, like market timing and chasing investment fads. The reason investors see much lower returns than these sector investments themselves is due to many, if not all, of the reasons I just mentioned.

For instance, if the investment doesn't do what the investor expected in the short term, they may feel pressured to change their mind and subsequently label it a bad investment or a mistake, thereby realizing a loss on the invested dollars or selling it prematurely before realizing any meaningful returns that might come in the future. In other words, after purchasing the investment, it may have produced very little to no return for months or even a few years while the investor's other investments are going up significantly. And so the investor sells the investment too early before the return starts to pick up. Although the reasons could be many, the point is these sector funds aren't typically invested in for longer-term goals but rather used as a tool for potential short-term gratification. And this helps explain the larger gap in returns for investors in this type of asset class.

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Now, there's actually one more asset class I want to briefly mention that I think many people may overlook in this study, and that is taxable bonds. The return gap in the study showed a 1% average lower rate of return for the average dollar invested by investors in taxable bonds over the same 10-year time frame ending December 31st, 2023. The reason this is notable is because of the lower volatility and risk in taxable bonds versus an asset class such as stocks.

Because of the lower risk profile of bonds, they tend to historically underperform stocks over long-term time periods, such as a 10-year time frame. So when an investor should reasonably expect a lower return from an asset class like taxable bonds compared to stocks, a 1% lower annual return due to the investor's own actions is relatively more powerful. In other words, investors are giving up 50% of the returns from their taxable bonds based on the returns shown in the study. What's more interesting is the exact reason why there is such a gap with an asset class with far less volatility than one like stocks. While the exact reasons for this aren't able to be explained by this research alone, in my opinion, it seems that rather than buying bonds and including them in an investment portfolio in order to meet a specific goal, it seems that many investors are buying them in hopes that they can reduce the overall volatility of their portfolios, but then frequently changing their mind by market timing and selling their bonds and deploying the money in another asset class that may have recently produced a better return.

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In other words, chasing returns. Another possibility is that investors are using their bond allocations to get cash and liquidity from their investment portfolios in order to spend and sell those bonds during volatile time periods. This can happen when goals aren't clearly set before choosing an investment allocation. It seems to me, in this case, that investors have primarily been tempted to chase returns of other asset classes over the last 10 years since stocks had significantly outperformed bonds during that time period, and that's the time period this study is reflecting.

Just as it always has been, I think many investors get carried away attempting to maximize overall returns in the short term rather than choosing allocations specifically for a particular goal at some point in the future. Again, this market timing or speculation on what asset class will outperform at any given moment is a losing game, which could explain this phenomenon, but we can't know for certain.

Market timing and speculation often lead to buying high and selling low, which is, of course, what we want to try to mitigate when investing. Another notable part of the mind-the-gap study looks at the gaps and returns based on how volatile the asset class or particular fund is, some of which I have already alluded to.

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One takeaway they found was that the more volatile the fund, the more likely investors are to mistime their investments, which makes intuitive sense since a higher amount of volatility is more likely to cause investors to act irrationally. The author of the Morningstar report notes investors particularly struggled to navigate 2020’s turbulence, adding money in late 2019 and early 2020, then withdrawing nearly half a $1,000,000,000,000 as markets fell only to miss a portion of the subsequent rally. That bad timing cost investors a negative 2% gap that year.

Again, if you wanna dive more into the numbers on this portion of the study, definitely take a look at the data they provide in the research. Again, there will be a link to it in the episode show notes. This research shouldn't be taken as a guide of what to invest in but rather used as a way to understand how an investor's own financial plan and behaviors can affect their investment returns over time. For example, simply because an allocation type of fund showed a smaller return gap than other specific asset classes doesn't mean these funds are better investments than the others. Ultimately, how you allocate your investments should be dependent upon the various goals you have for your money and the details surrounding those goals.

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In summary, the gaps in returns ultimately reflect money given up for nothing. In other words, it's essentially an additional cost for no value or nothing in return. And while minimizing other costs, such as the internal investment expenses of the funds or ETFs you choose, is important, it should not be considered in a silo. For instance, you can have two investors with the exact same time frame and specific investment held in their portfolios while one pays more expenses than the other. But, the one that pays more in expenses can still outperform the other over that same period of time even when the other person incurred less in expenses.

A significant portion of an investor's return can be influenced by the actions they take over an investing lifetime compared to the specific investments they choose. In my experience, most investors fare better by aiming to simply get the average returns necessary for as long as possible to meet their goals rather than consistently trying to get outsized returns with no definitive goals.

That does it for today's discussion. If you're managing your own investment portfolio, I encourage you to check out the recent Mind the Gap study available in the show notes. If you find the observations provided in today's show actionable, valuable, and insightful, please subscribe to or follow the show on your podcast app. And while you're at it, check out the Retired-ish newsletter to get more useful and easy-to-digest information on retirement planning, investments, and taxes once a month, straight to your inbox.

Of course, if you want to learn more about the topics I went over in the show or you want to ask a question to be answered on a future episode, you can find links to the resources we have provided in the show notes right there on your podcast app, or you can head over to retiredishpodcast.com/56. Thanks again for tuning in and following along. See you next time on Retired-ish.

Disclosure [00:20:44]:
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