Beating the Market Part 5 – Could our behaviour be part of the problem?

Yes. Investors routinely destroy value by over-trading and ignoring the impact of investment expenses and taxes. Even more troubling is the self-inflicted and avoidable damage that they do to their wealth by chasing past performance. Investors routinely chase investments with strong recent performance and avoid investments that have performed poorly. By doing so, they under-perform a simple buy-and-hold index fund.

In their paper Timing Poorly: A Guide to Generating Poor Returns While Investing in Successful Strategies, researchers Jason Hsu, Brett Meyers and Ryan Whitby used the CRSP Survivorship-Bias-free US Mutual Fund Database to investigate the behaviour of investors across 18,665 mutual funds from 1991 through to 2013.

They compared each fund’s time weighted return with its dollar weighted return. The dollar-weighted return accounts for monthly flows into and out of each fund from by investors; whereas the time-weighted return assumes that investors held a fixed amount in each fund for the entire time period.

Its industry practice to report time-weighted returns (i.e. assuming that investors buy–and–hold). Arguably this doesn’t accurately represent the behaviour of most investors, who vary the size of their investment over time. Thus dollar-weighted returns are a better representation of the return that the average investor in each fund would have earned.

The return gap or the difference between dollar-weighted returns and time-weighted returns is one way to measure the skill of mutual fund investors in picking the right mutual fund at the right time. Here’s what the researchers found.

Regardless of the fund category or style chosen, we observe that the average mutual fund investor’s IRR is always meaningfully lower than the buy-and-hold return and always worse than a strategy that naively buys and holds the S&P 500 index; this is true even on a gross of fee basis. Specifically, we find that certain mutual fund investors, such as growth strategy investors, are more prone to generate large return “gaps”—suggesting the possibility that specific categories of investors time their trades more poorly than others. These findings could also suggest that mutual fund investors, through their poor timing decision, are providing alpha to other investors.

Table 2 below lists the results of the study. Notice the fourth column from the left. It shows the difference between the dollar-weighted and the buy-and-hold returns for each mutual fund category. The difference across all funds was -1.94% per annum.

Table 2

That may not sound like much but consider this: the buy-and-hold return for the S&P 500 was 8.97% for the entire period.  A loss of -1.94% per annum is equal to 22% of the total return that an investor would have earned if they invested in a low cost index fund!

Perhaps the most interesting column is the column entitled “Average random DW Return” on the far right of Table 2. This is the dollar weighted return that investors would have earned, on average, if they increased and decreased their investment in mutual funds at random.

In all cases, the actual dollar-weighted returns were worse than the random dollar weighted returns. In other words, investors would have lost less money by tossing a coin to help them decide whether or not to invest more or less in their mutual funds!

It’s interesting to note that of all of the mutual fund styles investigated only value and small cap funds have, on average, a buy-and-hold return greater than that of the S&P 500. But the return gap of -1.31% for value and -1.55% for small cap funds meant that investors poorly timed investment decisions resulted in under-performance.

The researchers explain their results as follows.

Put in other words, while “value” managers have largely been successful in exploiting the value premium to outperform the market, the “value” investors, who ultimately allocate capital to these value managers, have managed to reverse the sign on the premium earned through their timing decisions. Specifically, they seem to allocate to value mutual funds when value stocks are “relatively” expensive and offer a low premium and vice versa.


We find a similar pattern for the average growth investor in mutual funds. However, this may be less interesting since the average growth mutual fund already underperforms the market. Indeed in a later section, we show evidence that growth fund investors produce the largest return deficit from timing.

This result may also explain why the value premium – cheap stocks earn higher returns than expensive stocks – persists, even though it has been used and researched for the last 90 years (emphasis added).

This observation may help motivate why the value premium has remained so persistent. One simply would not expect the value anomaly to be arbitraged away by poorly timed fund flows that have led to substantial “excess losses” instead of “excess profits” for value investors. Quite the opposite, the poor timing might be generating excess profits for others. Since equity mutual funds account for nearly 20% of the U.S. equity market, the dollar alpha supplied by mutual fund investors, through their timing, could be quite substantial…


Instead of wondering about the potential sucker on the other side of the value trade, we ask “why does the average investor in value mutual funds consistently give away the value premium?”

Hsu, Meyers and Whitby also investigated whether the return gap between dollar-weighted and time-weighted returns was affected by the mutual fund’s expense ratio. Table 3 shows that there was a positive relationship between high investment management fees and a larger return gap.

Table 3

Higher expense ratios are probably more likely to be present in mutual funds that invest “hot” or fashionable industry sectors or investment styles – the kinds of funds that are arguably more prone to performance chasing.  Also, investors who qualify for and purchase institutional (lower cost) share class mutual funds experience a smaller return gap. This could be because they are more sophisticated and therefore more patient. In other words, they realize that the performance of active fund managers is cyclical and that chasing past performance is usually a bad idea.

In summary, the results lent themselves to the following interpretation.

Our findings appear to be consistent with the hypothesis that investors attempt to time their allocation to mutual funds. Our evidence supports the idea that the average investor chases performance and allocates to value funds after periods of strong relative performance and vice versa. Unfortunately, this coupled with the evidence on the mean-reversion tendency for value stock outperformance, implies that they time poorly.

The return gap isn’t just a problem for equity investors. Investors behave similarly across all asset classes. For example, the table below is taken from a study by Morningstar – Mind the Gap: Why Investors Lag Funds – in 2013. They too found that there is a significant return gap between the returns that mutual funds report and the returns that the average investor in each fund experiences.

Morningstar return Gap

The worst return gap was found in international equities as Morningstar explains:

The biggest gap was in international stocks, where the typical fund returned 10.0% annualized over the past 10 years versus 6.8% for the average investor. Why the gap? Emerging markets are volatile, and some investors are prone to buying after rallies and selling after downturns. It probably also reflects the fact that investors are mostly in diversified foreign funds, where emerging markets take up a small portion of assets. These funds lag emerging markets’ 10-year return because developed markets lagged over that time.

The return gap can also be a problem for defensive asset classes such as bonds. Investors seem to move in and out of safe assets such as taxable and municipal bonds. They moved into these assets during the worst of the financial crisis, missing out on the rebound in riskier assets such as shares, and then moved back into riskier assets, missing out on the capital appreciate in bonds due to lower interest rates.

What can we do about our tendency to make behavioural errors that cost us money? There are five things that we can do that can help:

  1. Buy-and-hold index funds. We would have out-performed the average investor by approximately 2% per year, enjoyed very low investment fees and minimized taxes. Of course this means giving up the opportunity to beat the market. But as we’ve seen from the results above, very few investors are disciplined enough to control their behaviour. Consequently, an investor earning the market return minus a modest fee will, on average, beat the majority of investors.
  2. Avoid expensive mutual funds and investment strategies. All other things being equal, the higher the fee, the lower the net return.
  3. Stop chasing past performance.
  4. Favour active strategies that have a track record of out-performing the market, such as value investing.
  5. Be patient. Investors using active investment strategies need to be patient. The success or failure of an active investment strategy needs to be measured in years, not months (see Beating the Market Part 2 – Short Term Under-performance). If you can’t wait that long, see point 1 above.


For earlier blogs in this series:

For more examples of irrational investor behaviour:

For more information on dollar-weighted investment returns and return gaps:


  1. Market Fox, it is even worse than you say: if the Equity Risk Premium (equities over long-duration nominal bonds) was 5%, and investors were to lose 2% from poor market timing, plus another 0.5% from manager fees, they have missed out on 50% of the Risk Premium but accepted about 100% of the market risk that goes with it!

    You also raise the idea of investing in value funds – as a cautionary tale, it is important to note that obtaining the so-called Value Risk Premium requires that investors can last the distance with such a strategy, and continue to invest even when returns are terrible compared to alternative strategies. We have seen such a five year period recently.

    Finally, it is interesting to think about who are the parties that capture the difference between the time-weighted and money-weighted returns that you talk about above. Some of that will fall to managers as fees, and another part to investment banks and counterparties through the trading impacts, but what about the rest?


    • Thanks for your comment.

      Your point about the equity risk premium is a very valid one. All of the risk for only 50% of the risk premium sounds like a very bad deal to me.

      The longer I spend working in the investment industry, the more that I come to the conclusion that finding the “right” investment strategy is only half the battle. Actually, its probably even less than half the battle.

      Even more important is having the right expectations, understanding what you’re doing and why and therefore being able to follow your strategy in a disciplined manner over time.

      As the study by Hsu et. al. illustrates a winning strategy like value is still a losing strategy if people use it incorrectly.


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