Emotion and financial decisions go hand in hand. After all, the often laborious plight of acquiring funds for investments is tied to the hope that it will bring you one step closer to your goals. Emotions can often affect our investing strategy and cause us to deviate from actions that are in our long-term best interest. This is especially the case if you don’t have structure to govern your decision making. Investors can fall victim to the 24-hour news cycle, dialling into market volatility and how it effects their portfolios. We often forget to turn the spotlight on our own behaviour which can be the ultimate driver of returns.

Our annual Mind the Gap 2024 study aims to examine the gap between investor results and reported total returns of a fund. The overall findings show that the average dollar invested in US mutual funds and ETFs earned 6.3% per year over the 10 years to Dec 2023. This was 1.1% less than the average fund’s total return over the same period (assuming an initial lump-sum purchase).

mind the gap survey

So why does this happen?

The returns gap stems from mistimed purchases and sales which are likely driven by emotionally irrational decisions. The pandemic was a particularly difficult time for investors as many incurred heavy timing costs in 2020 (leading to an even wider 2% gap that year). This is typical as the gap widens as volatility increases. The economic uncertainty and the resulting investor confusion saw an inflow of funds in late 2019 and early 2020, followed by a mass exodus as markets fell, only for many investors to miss the rally over the ensuing months.

Let’s take the S&P 500 for example: an investor who withdrew funds as they began plummeting in February 2020 missed out on the subsequent market rally of 2020 and 2021, which left markets up 40% by year end. Now this isn’t a lesson on timing the market to capitalise on the highs and lows. In fact, it encourages the opposite. An investor who had held steady and remained invested throughout would now be rewarded with at a 108% return (as of 30/01/25).

Below are a few emotional biases to be aware of before making an investing decision.

Loss-Aversion

Have you ever experienced the sunk cost fallacy? When you’ve invested too much time, effort or money into a pursuit which is failing but you can’t seem to let it go? This is an innate tendency to contribute more to an endeavour even if it no longer is working out.

Performance-chasing is a trap for investors seeking to maximise returns. I am no stranger to falling victim to this mentality as previously discussed in how I lost all my savings through a poor investment decision. An ill-timed and poorly thought-out investment into Zip Co (which subsequently crashed) left me clinging onto the funds, despite watching my portfolio fall by 60%,70%,80% then finally selling at 90% down. This is a classic example of loss aversion under distress.

I double downed and gambled the opportunity cost of withdrawing sooner and reinvesting in something else. Of course, there is no guarantee that the subsequent investment would have performed any better, however it is important to set boundaries based on your risk appetite. If you base an investment decision on a business you truly understand (which I didn’t), periods of underperformance are unlikely to deter you over the long-term.

Overconfidence

There are some similarities between stock market investing and gambling. Depending on the approach you take as an investor there may be resemblance. To successfully invest in individual stocks, an individual needs at least one of the four following advantages:

Analytical edge – better use of existing information or deep knowledge of an industry

Informational edge - access to more or better information

Behavioural edge – better control of emotions and actions

Structural edge – absence of career or industry pressures faced by professionals

Simply put, overconfidence bias can often manifest itself when an investor has inflated perceptions about their investing edge. For example, an investor working in the lithium industry may assume they have an analytical edge when investing in lithium companies. At its worst, this turns into overconfidence and can leave a portfolio vulnerable to heavy sector concentration.

The Mind the Gap study found that the narrower the strategy the harder time investors have capturing total returns. By nature, narrower funds tend to be more volatile, and the study suggests a link between this higher volatility and wider investor return gaps. Furthermore, these strategies can be higher maintenance, forcing investors to make buy or sell decisions during fraught times. For example, the recent NIVIDIA sell off saw the overly exposed, narrow strategy funds take a hit that was enough to make investors stomachs churn.

Morningstar is a proponent of diversification. Investors benefit from the humility of acknowledging that their first favourite pick may perform no better than their 20th. An even more humbling figure is that only 1% of ASX listed companies survive over the long-term and build a profitable business. Having confidence when investing isn’t necessarily a negative trait, however it is important to consider the viability of picking the 1% of companies that succeeds.

Self-control

Finally, we come to the last emotional investing bias, self-control. The idea of investing is embedded in delayed gratification and therefore, self-control. The concept of forgoing cash flow now for the goal of realising greater returns in the future requires discipline.

I refer to an article written by my colleague Joseph Taylor in which he explores the downside of overtrading in his own portfolio. Joseph reflects on the role of the vast (and often misguided) investment advice accessible through social media, coupled with not keeping the long term goal in mind. In an era of increased information availability, self-control is a critical bias to overcome to avoid overtrading and performance chasing.

The Mind the Gap study interestingly noted that ease-of-use was also attributable to shrinking investor return gaps. They examined the case of allocation funds (typically used in defined contribution plans e.g. superannuation) vs narrower funds which allowed for irregular purchases and sales. The research found that the mechanised nature of allocation funds helped avoid the potentially large timing costs of making large, ad hoc transactions. We may be able to conclude that when self-control was imposed on the investor (in the case of mechanised allocation funds), overall returns were higher. The narrower funds where investors were freer to exercise active management saw trading weigh on dollar-weighed returns of the overall portfolio.

I consider these findings as a reflection of the ‘set and forget’ strategy vs the active management strategy. As we all know, time in the market will always outperform timing the market. Imposing self-control on your portfolio through a mechanised investing structure is a good alternative for those who find it difficult to exercise self-control in the general market.

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