The Behavior Gap: How Retirement Investors Can Avoid It

Taylor Schulte: The average mutual fund and exchange-traded fund gained about 7.7% per year over the last 10 years ending December 31st, 2022.

The average person investing in those same mutual funds, on the other hand, gained about 6% per year during the same time period.

In other words, investors underperformed the exact funds they were investing in by about 1.7% per year over the last 10 years.

And contrary to what you might be thinking, investors didn’t underperform because of high fees or taxes.

Investors underperformed because of poorly timed purchases and sales of the funds. In other words, they underperformed because of their investing behavior.

And that’s precisely why this gap between the average investor's return and the average fund return is widely referred to as the Behavior Gap.

Welcome to the Stay Wealthy podcast, I’m your host Taylor Schulte, and today I’m discussing the recently updated Mind the Gap study published by Morningstar.

I’m sharing what asset classes had the highest and lowest behavior gap over the past 10 years, the role volatility plays in investing behavior, and three things retirement investors can do to earn more of their chosen investment funds' total returns.

To grab the links and resources from today’s episode, just head over to youstaywealthy.com/199.

To recap, the average mutual fund and exchange-traded funds total return for the last 10 years ending Dec 31 2022 was 7.7% per year.

The average investor's total return in the exact same funds over the exact same time period was 6% per year.

Put simply, investors missed out on about one-fifth of their fund investments’ average net returns over the time period measured.

And these results have been consistent year after year, decade after decade.

Investors, on average, continue to be negatively influenced by their emotions and behaviors, leading them to make poorly timed buying and selling decisions.

It turns out that buying and holding is easier said than done.

As my friend Carl Richards puts it in his book titled “The Behavior Gap:”

“It’s clear that buying even an average mutual fund and holding on to it for a long period of time has been a pretty decent strategy. But real people don’t invest that way. We trade. We watch CNBC and listen to Jim Cramer yell. We buy what’s up and sell what’s down. In other words, we do exactly what we all know we shouldn’t do.”

He goes on to say:

“The more expensive stocks (or houses) are, the more risky they are–yet that’s when we tend to find them most attractive. In short, investors as a group tend to be horrendously bad at timing the market. It makes far more sense to ignore what the crowd is doing and base your investment decisions on what you need to do to reach your goals.

But man, is that hard to do. It’s not that we’re dumb. We’re wired to avoid pain and pursue pleasure and security. It feels right to sell when everyone around us is scared and buy when everyone feels great. It may feel right. But it’s not rational.”

I think one of the traps many of us fall into, myself included, is that we think we know better. We think we’re smarter than the investors these studies reference. We think that we can avoid falling victim to the behavior gap because we’re financial experts and/or students of the market.

And then we get caught off guard and make a poor decision with our money or investments, reminding us that we are all, in fact, human. As Carl put it, we’re all wired to avoid pain and pursue pleasure and security.

And, in my mind, admitting that our emotions can lead or even tempt us to make irrational money decisions is an important step – it creates space for us to learn how we can narrow the behavior gap and make better decisions with our hard-earned money. Knowledge is power, but only if we’re open to absorbing the knowledge, learning, and improving.

I’ve read Carl’s book more times than I can count, but every time I open it – like I did for today’s episode – I walk away with something new and helpful that reinforces (and advances) the knowledge I’ve gained over the last two decades. And I’m reminded that mastering our behavior – especially as it relates to money and investing – is not like riding a bike. It’s more like playing golf. It requires ongoing attention, practice, and a whole lot of patience.

So, while the Stay Wealthy community likely isn’t representative of your average investor, I think we can still benefit greatly from continuing to study reports like the Mind the Gap paper from Morningstar.

With that, let’s dive into three key takeaways from the most recent study.

The first takeaway is that sector funds have the highest behavior gap out of all the investment categories. Over the last 10 years, investors underperformed the very sector funds they were investing in by 4.38 – almost 3x the weighted return gap for all categories. Sector funds are funds that invest in companies that operate in a particular industry or sector of the economy.

For example, healthcare, semiconductors, energy, or financial services. Interestingly enough, sector funds, on average, had the highest average annual return of 10.8% out of all the categories measured. But again, investors in those funds significantly underperformed, achieving an average annual return of only 6.42%.

The category with the smallest behavior gap, which has been consistent every year this study has been done, is asset allocation funds. Asset allocation funds over the last 10 years had an average annual return of 6.44%, while investors in those funds had an average return of 5.98%, a gap of only 0.46%. U.S. stock funds had the second smallest gap of 0.79%.

The second key takeaway is that large-cap U.S. growth stocks didn’t have a gap at all. In fact, investors outperformed the funds they invested in by about 0.10%. However, this is likely more of an outlier than a trend given that the behavior gap has been fairly significant for this asset class in all prior years.

The popularity, excitement, and healthy performance of large growth stocks are likely contributors to investors being able to hold on and outperform over the last 10 years. Emerging markets and international large-cap stocks had the two highest behavior gaps during the time period measured of 1.69% and 1.35%, respectively.

In other words, investors had a much easier time buying and holding U.S. stock funds that own companies they are likely more familiar with than overseas funds.

The third takeaway from the study is that investors are more likely to experience a larger behavior gap when investing in more volatile funds. For example, investors in U.S. taxable bond funds with the highest volatility over the last 10 years underperformed the funds they invested in by 2.08%.

However, investors in the least volatile taxable bond funds only underperformed by 0.85%. These results – which have been consistent in this category year over year – reinforce why I remain a big advocate of owning safe AA-AAA rated bonds that don’t begin to behave like stocks during difficult time periods. Not only do highly volatile bonds present unwanted risks to a retirement portfolio, but they also increase the chances that an investor's behavior gets the best of them.

Bond funds weren’t the only category to highlight the relationship between volatility and the behavior gap. On average, investors in the least volatile funds across all categories underperformed the funds they invested in by around 0.9% per year over the last 10 years, which was a full percentage point less than the most volatile funds.

In short, investors are able to stick with lower volatility funds – and earn more of their fund investments’ total returns – than higher volatility funds. As I’ve talked about before, one of the benefits of diversification is reducing risk and volatility in a portfolio. And reducing risk and volatility makes it easier for inventors to stay the course. Once again, the best investment is the one you can stick with.

Before we go any further, it’s important to acknowledge that Morningstar is not the only company to study the behavior gap. The DALBAR study is another popular one that has come to similar conclusions about investor behavior. However, both of these studies and their methodologies continue to receive criticism, with some finance experts suggesting that the gap doesn't exist or it's much smaller than these studies lead you to believe.

I'm not gonna dig into that here today, you can Google around to read more about some of the criticism. But my good friend and colleague Cullen Roche had one of the better rebuttals to this criticism a couple of years ago when he made the point that 60% of investible assets are still being invested in high cost, actively managed mutual funds.

And since 80% of those high cost active funds underperformed the broad market indexes, it's pretty safe to say that the behavior gap is a real thing.
For example, even if all of those investors buy and hold their high cost actively managed funds, naturally 80% of them are going to underperform and experience a gap between their returns and the benchmark.
He went on to say,

“I don't know the exact cause of the behavior gap and I don't think I really need to. All I know is that the investment world is a minefield of expensive options, that the average investor has a very difficult time actually understanding and navigating financial literacy is a mind-mockingly huge problem in the USA and around the world.

And while people who buy stocks and bonds are probably relatively financially literate, there's still huge amounts of evidence that these investors make bad decisions pretty consistently.”

Morningstar acknowledged in this year’s report that investors have made some small strides over the years but there is, of course, always room for improvement. As a starting point, there are three things an investor can do to improve, narrow their own behavior gap, and capture more of the returns delivered by the funds they are investing in.

Number one, keep it simple and stick with plain vanilla, broadly diversified funds or asset allocation funds. As Morningstar put it,

“Allocation funds help mitigate the risk of mental-accounting mistakes that investors are prone to, such as buying more of a high-performing stand-alone strategy and selling a lagging one when they should be doing the opposite.”

Number two, avoid exotic, concentrated funds as well as funds with higher volatility. Especially funds with higher volatility that don’t match up with your stated goals. Most investors will be better off over long periods of time maintaining proper diversification, matching the risk and volatilityof their investments with their goals, and keeping investment costs low, all of which would lead them away from funds that have, historically, had the highest behavior gap.

Number three, perfect is the enemy of good. Or, said another way, good beats perfect. As Morningstar concludes, evidence suggests that investors had greater success by favoring simpler solutions – solutions they understand and can stick with over long periods of time. As Carl Richards puts it in his book:

“This tendency to seek comfort in complexity even shows up in emergency rooms. A physician friend of mine tells me that patients are often disappointed when he offers a prescription that is relatively simple: “Go home and get some rest” or “stop smoking and eat a little less junk food.”

They can’t believe – in fact, they’re disappointed to learn – that there is a simple solution to their health problem. Why the disappointment? You’ve probably guessed the answer already: we often resist simple solutions because they require us to change our behavior.”

On that note, if you think you would benefit from professional help and want to learn more about how my firm implements simple investment portfolios to help our clients navigate the complexities of retirement, please reach out.

We remain highly specialized and are dedicated to helping people over age 50 who are retired or nearing retirement reduce their tax bill and turn their nest egg into a retirement paycheck. To help you evaluate our firm (and others you might be considering), we are currently offering a free retirement and tax analysis.

We will answer your big retirement questions, produce a custom tax analysis, and provide actionable recommendations, allowing you to see exactly how our firm can help before paying us a single dollar.

To learn more, just go to www.freeretirementassessment.com. That’s freeretirementassessment.com. If easier, you can also click the link in today’s episode description in your podcast app.

And, as always, if we don’t have the right expertise to help, we will happily help you find a financial professional who does. After all, you wouldn’t go to a heart surgeon if you needed knee surgery.

I hope you enjoyed today’s episode, thank you.

Thank you, as always, for listening and I will see you back here next week.

Episode Disclaimer: This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services.