Lack of patience helps to create ‘the investor gap’

Published: June 7, 2016 3:13 p.m. ET




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Each year, Morningstar analyzes the monthly flow of money into and out of mutual funds to estimate the return realized by the average investor in each fund. It then compares this to the fund's annual return. The difference, if any, is called the "investor gap." Any gap indicates that investors are underperforming the very funds they own. In essence, it's the cost of attempting to time the market instead of adopting a buy-and-hold strategy.

What happens when you don’t leave well enough alone

The latest report released last August, reveals a 1% annual investor gap for domestic stock-fund investors for the 10 years ending Dec. 31, 2014. Put into dollars and cents, $10,000 invested in the average domestic stock fund on Jan. 1, 2005, if left alone and ignored, would have grown to $20,553 by Dec. 31, 2014. Unable to leave well enough alone, the average investor's fund balance would have grown to only $18,754.

Blaise Pascal said, "All of humanity's problems stem from man's inability to sit quietly in a room alone." For our purposes I'll modify Pascal's observation to, "The investor gap stems from man's inability to sit quietly in a room and ignore his portfolio." Numerous studies of investor behavior reveal that the more you ponder your portfolio, the more you'll trade and the bigger your personal investor gap is likely to be. So, what are some causes of the investor gap?

What impatience costs you

Not content to sit quietly and quit tinkering with their portfolios, many investors are more active than prudence would dictate. Combine a limited understanding of financial concepts and the lack of a written financial plan to help prevent imprudent, emotional investment decisions and, voila, the investor gap. Strategies that have worked over the long haul often appear to be foolish in the short term, almost guaranteeing that portfolio tinkerers won't leave well enough alone.

We often make investment decisions in response to political events — especially ones done by those who have disappointed us. This is more common than we would like to admit and one that has impoverished the portfolios of many political conservatives the past seven years. This year's presidential-election circus is just getting into high gear, and it is inevitable that many investors who are disappointed by the outcome will make decisions that will be counterproductive to their long-term financial welfare.

Despite all the warnings that past performance is no guarantee of future returns, investors still chase performance. They equate good performance with manager skill, not realizing that the manager might just have been lucky. Sadly, much of this performance chasing is done following the advice and guidance of financial professionals. Successful money managers are popular guests in the financial media, not because they have some special insight or remarkable strategy, but because they are sure to attract clicks, ears and eyeballs.

What leaving well enough alone does

Investors become rattled by ordinary market volatility. Historically, domestic stocks have experienced a temporary intra-year decline of 10%-15% and a 30%-50% decline every five years. Whenever the stock market goes into one of its swoons, investors are more likely to act as if "this time, it's different" rather than the more likely "this, too, shall pass."

Most investors seeking to learn more about investing choose a poor source for that information — the financial media. (This is better than seeking financial advice from your brother-in-law, but barely.) Financial journalism rarely, if ever, identifies financial planning as the essential component of successful long-term investing; the emphasis is always on performance. It gives the impression that investing is primarily a timing and selection activity.

As a result, you get the endless "What to Buy Now" articles. The successful investor needs patience and discipline, two attributes not often encouraged by the financial media. What's worse, it offers a relentlessly pessimistic outlook, always presenting worst-case scenarios to today's real or imagined "crises," scaring many investors away from stocks.

Changing your behavior

Many children have imaginary friends and, sadly, so do many investors. These imaginary friends are market forecasters whose predictions are irresistible to some investors. Instead of asking, "Why would anyone offer me free investment advice?" misguided investors often say "Eureka!" and follow predictions to their eventual regret. The self-glorifying twaddle of market forecasters is rarely insightful, usually just an extrapolation of recent events and more likely to fill your ears instead of your wallet.

The investor gap is created by poor investor behavior in response to unpredictable, periodic, temporary market declines. It will exist as long as investors try to time the market in order to gain the upside and avoid the downside. If you're endeavoring to do this, you're delusional and any financial forecaster (or advisor) who encourages you to do so is a devil. The large exodus of money from stock mutual funds in response to the market decline in January and February will keep the investor gap alive and well, ensuring that in 2016 investors will continue to underperform the very funds that they own.

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