Investors vs. Funds: How to Overcome the Investment Performance Gap

What Is the Performance Gap?

The gap in investment performance, which Carl Richards calls the “behavior gap,” is the difference between an investor’s returns and the average returns of the investment over the same period. According to Morningstar, Inc., in its report, “Mind the Gap 2024: A Report in Investor Returns in the US,” most individuals in the US who invest in mutual funds and exchange traded funds have underperformed their investments by about 1.1% on average in recent years. This underperformance has been referred to as “the behavior gap” because human behavior is the primary variable differentiating the two sets of returns. Several well-intentioned and seemingly logical behaviors can actually hinder your financial performance.

What Behaviors Tend to Decrease Investment Performance? 

Checking Your Investment Accounts Often

Many investors feel the urge to constantly check their investment portfolios and compare their returns to the overall market as well as to certain benchmarks, such as the S&P 500 or the Dow Jones Index. Certain types of financial media feed into this impulse, offering a constant stream of information regarding past and current performances of certain stocks, speculations on market trends, and opinions on investing strategies. Consuming financial media and keeping a close eye on your investments are not bad habits in and of themselves, but frequently monitoring your investment accounts can cause anxiety around normal market fluctuations that may lead to bad money-making behavior.

Emotional Decision-Making

Anxiety from checking your investment accounts too often can lead investors to make impulsive, emotionally driven financial decisions, such as selling shares of a fund that has not been performing well and replacing it with a different fund that is performing better. This impulse can lead investors to sell low and buy high, reacting emotionally to market volatility rather than staying the course with a well-thought-out, long-term investment strategy. Buying funds at their peak and selling them during a downturn results in lower overall returns.

Attempting to Time the Market

One of the most significant factors contributing to underperformance is investors’ desire to time the market. Their goal is straightforward and seemingly logical: buy low and sell high. However, because it is impossible to accurately and consistently predict the precise times a fund will reach its peak, these investors often miss out on the benefits of sustained market growth. Market timing requires predicting short-term fluctuations, which is notoriously challenging even for experienced investors. Investors who try to time the market often end up buying after prices have already risen or selling after they have dropped, leading to suboptimal returns. This approach not only increases transaction costs but also results in missed opportunities for gains that come from holding investments for the long term.

What Are Some Strategies to Increase My Investment Returns?

Define Your Goals

When your financial goals are ambiguous, it is much easier to chase performance and be swayed by market fluctuations. Therefore, it is essential to identify your long-term financial goals and adopt an investing strategy that will allow you to achieve them. Whenever you consider changing your strategy, you should carefully consider whether that change will realistically bring you closer to achieving your goals.

Understand Your Risk Tolerance

If you tend to react emotionally and buy or sell securities based on a sense of fear or urgency, you are likely investing above your risk tolerance threshold. “Risk tolerance” refers to one’s ability and willingness to endure market fluctuations and potential losses in pursuit of higher returns. By accurately assessing your risk tolerance, you can build a portfolio that aligns with your comfort level and long-term financial goals. This alignment will help you stay invested through market volatility rather than reacting impulsively to short-term market movements. In Chicago, set off words that are being defined by quotation marks.

Adopt a Long-Term Perspective

Adopting a long-term perspective allows you to ride out market volatility and benefit from the compounding effects of your investments over time. When you commit to a long-term strategy, you reduce the impact of short-term fluctuations and avoid the pitfalls of market timing. This consistent approach helps you stay aligned with your financial goals, prevents emotional decision-making, and maximizes the potential for growth. By remaining patient and sticking to your established long-term plan, you can capitalize on market recoveries and narrow the gap between your investment performance and the funds’ performance.

Work with a Financial Advisor

Working with a financial advisor can help you develop a well-structured investment strategy tailored to your goals and risk tolerance. Advisors can provide valuable insights and help you avoid common mistakes that lead to underperformance