Why Investors Underperform and How to Close the Return Gap
Chasing past returns causes investors to buy high and sell low.
30-second summary
Most investors underperform the broader market not because of high fund fees, but because of bad timing driven by performance chasing. When investors buy funds after periods of strong performance and sell after steep declines, they lock in losses and miss subsequent rebounds. This creates a return gap of 1.5% to 2% annually on average—and even higher in volatile or specialized funds. Because recent underperformance often depresses asset valuations and raises future expected returns, switching out of underperforming funds destroys wealth. To avoid this trap, investors should choose a diversified strategy they can stick with through downside volatility.
Core concepts
The Performance Gap
The performance gap is the difference between an investment fund's published return and the actual average return earned by investors in that fund. Because people tend to buy into investments after a run of high returns and withdraw money after poor performance, investor dollar-weighted returns consistently lag the fund's time-weighted returns by 1.5% to 2% annually.
The ARK Innovation return disconnect
During Cathie Wood's ARK Innovation Fund boom, retail investors flooded into the fund after it posted massive gains. However, when the fund subsequently experienced sharp losses, many investors sold off their positions to minimize further downside. This timing mismatch resulted in a massive gap between the fund's published record and actual investor outcomes. While the fund itself maintained positive time-weighted returns from inception to May 2023, the average investor suffered double-digit negative returns because most capital entered near the top.
Valuation Mean Reversion vs. Performance Extrapolation
Investors often assume that recent fund winners will continue winning and recent losers will continue losing. In reality, underperforming funds often hold assets whose valuations have dropped, which increases their expected future returns. Conversely, recently successful funds hold highly valued assets with lower expected future returns. Firing recent losers and buying recent winners systematically tilts portfolios toward lower expected returns.
5-minute action
Identify and Lock In Your Holding Strategy
- Review your current investment holdings and note if any recent additions were prompted by headline gains or popular hype.
- Establish clear, written criteria for rebalancing and selling that rely on asset allocation targets rather than recent returns.
- Commit to holding your core index or diversified funds during market dips rather than executing panicky sell orders.
ExampleWrite down your target allocation (e.g., 80% broad index ETFs, 20% bonds) on a card and set a rule to rebalance annually regardless of recent market performance.
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