Behavioural Finance
The Behaviour Gap
Why the returns investors actually earn are often lower than the returns of the funds they own, and how timing decisions create this gap.
A fund might report an average return of 10 percent a year. Yet the average investor in that fund might have earned only 8 or 9 percent. The difference is called the behaviour gap.
Why the gap exists
A fund’s reported return assumes you invested at the start and held until the end. But real investors:
- Buy after rises, when optimism is high.
- Sell after falls, when fear is high.
- Switch funds chasing performance.
- Stop SIPs during downturns.
Their money is invested at the wrong times, so their actual returns, called money-weighted or dollar-weighted returns, fall below the fund’s time-weighted returns.
The evidence
Research firm Morningstar publishes regular studies called Mind the Gap. Its studies of US funds have found that investors’ returns lagged the funds’ reported returns by around one percentage point a year on average, with larger gaps in more volatile funds such as sector funds.
Compounding the cost
A gap of one percentage point a year seems small, but over 30 years it can reduce final wealth by a quarter or more.
Why volatile funds have bigger gaps
Big swings tempt investors to act on emotions. Steadier funds, such as balanced funds, often have smaller gaps because investors are less likely to panic.
Closing the gap
- Automate investments through SIPs.
- Rebalance on a schedule rather than by feel.
- Avoid checking too often.
- Choose simpler, diversified funds you can stick with.
- Write down your plan and reasons for investing.
In India, the steady growth of SIP investing, where many investors continued investing through downturns, has helped many avoid the worst timing mistakes.
Two investors own the same fund. In March 2020, one stops her SIP and sells in panic; the other continues investing. Over the next two years, the fund recovers strongly. The second investor's returns match the fund's; the first investor's returns lag far behind.
Your return depends on when you invest and withdraw. Poor timing can leave you well behind the fund.
- The behaviour gap is the difference between fund returns and investors' actual returns.
- Buying high, selling low and switching funds create the gap.
- Morningstar studies found a gap of around one percentage point a year.
- Automation, rebalancing and simple funds help close it.
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