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Investors don't earn market returns, according to a recently updated study from Morningstar, a Chicago-based investment research company. The research, titled “Mind the Gap 2019” and conducted each year by Russel Kinnel, director of manager research, builds on the work demonstrating that higher expenses lead to lower returns. It also measures the impact of poor timing.
According to Morningstar, over multiple 10-year periods, the average investor underperformed the funds they invested in, for all three major asset classes. This chart shows the annualized returns and gaps:
Alternative funds are complex funds that are supposed to zig when the market zags. However, they are prone to low returns and investors also time their purchases particularly poorly, such as buying after strong performance.
Another key finding was that investors in asset allocation funds, like target date retirement funds, actually did an average of 0.22 percent better annually than the funds themselves. That's because these funds must stick to an asset allocation, meaning they have to buy when stocks go down and sell after stocks perform well. It's just the opposite of human nature.
These gaps are strictly from poor timing and do not include the fees of the underlying funds. Morningstar has long shown that lower fees are correlated with higher returns for each asset class.
But the research indicates that investors do more performance chasing with expensive and volatile funds, making a bad situation even worse.
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Boring is better
I spoke with Kinnel, who told me, “Boring and cheaper is better because there is less fear and greed at work.” It's that fear and greed that leads us to buy high and sell low. He said to “stick to a plan,” which means you must set an asset allocation and commit to it. He also noted many investors underperform by several percentage points annually because they embrace the fear-and-greed cycle.
If the prospect of buying after a market plunge makes you queasy, you can harness the power of inertia and buy a low-cost target date retirement fund. These funds own stocks and bonds and must stick with a target allocation trajectory. That means they will automatically buy more stocks after declines and sell after surges.
Such low-cost index target date funds are offered by fund families such as Fidelity, Schwab and Vanguard. Though target date funds are very common in employer 401(k) plans, they also can be purchased directly from these fund companies.
My advice is always to invest rather than speculate by buying a fund after stellar performance. Investing, in an eight-word nutshell, is simply: “Minimize expenses and emotions; maximize diversification and discipline."
That is not to say that simple is synonymous with easy. Build a broad ultra-low-cost portfolio of stock and bond funds that will help provide the discipline to ignore your emotions and stick with a plan. You work hard for your money and to build your nest egg. Don't give it away in fees or emotions — enjoy it.
Allan Roth is the founder of Wealth Logic, an hourly based financial planning firm in Colorado Springs, Colo. He has taught investing and finance at universities and written for Money magazine, the Wall Street Journal and other publications. His contributions aren't meant to convey specific investment advice.