Why investors trail their own investments

Suppose a fund reports a return of eight percent a year over a decade. The figure is accurate, audited and not misleading in any way.

Now suppose you could go and ask every person who held it during that decade what they actually earned. There is no reason for the average of their answers to be eight percent, and a structural reason for it to be lower. Nobody has lied and no fee has been hidden. The two numbers are answering different questions.

The arithmetic, in two years

Take a fund with a very simple history. In its first year it returns 50%. In its second it falls by a third.

Over the two years together, one unit present throughout ends where it started: up a half, then down a third, back to level. The fund reports a two-year return of zero, correctly.

Now put an investor into it. They start with 100 at the beginning of year one and end that year with 150. The performance has been excellent and it has been noticed, so they add 900 — a perfectly ordinary human response to a good year. They now hold 1,050 going into year two, which falls by a third to 700.

They contributed 1,000 in total and hold 700. The fund returned nothing and its investor is down almost a third, and no charge, error or misconduct is involved anywhere in the story. Most of the money was not there for the good year, and all of it was there for the bad one.

Not the same thing

The fund's reported return

What one unit of money would have earned by being present for the whole period.

Measured in

Return per period, chained together, with the size of the pot deliberately ignored

For example

The headline figure on the factsheet and in every comparison table.

Chase it alone and

It describes an investor who arrived on day one and never moved, which is nobody, and it is the only figure most people ever see.

What the investors earned

What the money actually put in actually earned, weighted by how much was present when.

Measured in

Return on the money, weighted by amount and by time held

For example

Contributing 1,000 in stages and holding 700 at the end, in a fund that reported zero.

Chase it alone and

It mixes the quality of the fund with the timing of the holder's decisions, so a poor number does not tell you which of the two was responsible.

Which is which? Put each one on a side.

• The figure used to rank funds against each other

  The fund's reported returnWhat the investors earned

• The number that determines whether you can afford the thing you were saving for

  The fund's reported returnWhat the investors earned

• A return that improves when a holder adds money just before a good stretch

  The fund's reported returnWhat the investors earned

• A return unaffected by anybody adding or withdrawing anything

  The fund's reported returnWhat the investors earned

Why the money moves at the wrong times

The pattern is not stupidity, and describing it as stupidity is both unkind and useless, because it suggests the remedy is trying harder.

Good performance is the advertisement. A holding is most visible, most discussed and most recommended immediately after a strong run. That is when money arrives — not because people are chasing, exactly, but because that is when they hear about it.

The bad stretch is when the money is needed. Falls cluster with the events that cost people their income, which is the same clustering from the liquidity lesson. Withdrawals happen at the bottom partly because that is when withdrawals are necessary.

Holding through a fall is genuinely unpleasant. Watching a number decline for eleven months is not a small ask, and treating it as one is how plans get written that nobody can follow.

Predict

Two investors hold the same fund for the same ten years, with identical total contributions. One paid in a fixed amount every month; the other paid in whenever they had spare cash and felt positive about it. What separates them?

Choose one answer

Nothing — same fund, same total, same periodThe fixed schedule bought more units when prices were low, without anyone deciding toThe discretionary investor did better, because they could avoid bad periodsThe difference is entirely down to luck

Lock in answer

What the gap is made of

Three separate things get bundled into the phrase, and separating them is useful because only one of them is behavioural.

Timing of flows. The arithmetic above. Money present for the bad stretches and absent for the good ones.

Switching between holdings. Selling one thing after it has done badly and buying another after it has done well, which is the same effect applied across funds rather than in and out of one, plus the costs of doing it.

Costs of the movement. Every switch has a transaction cost and, where gains are realised, brings a tax charge forward from later to now. The previous lesson showed what bringing a charge forward does over a long period.

Only the first two are about behaviour. The third is a mechanical consequence of the first two, and it is why the gap is larger than the timing alone would produce.

Check

What do the arrangements that close this gap have in common?

Choose one answer

They rely on the holder being unusually disciplinedThey remove the decision from the moment it would be made badlyThey involve holding less volatile assetsThey require better forecasting of market conditions

Check answer

Worth remembering

• A fund's reported return assumes one unit of money present throughout; an investor's return weights by how much was present when.
• The two diverge whenever money arrives and leaves unevenly, which it always does.
• In the worked example a fund returning zero over two years left an investor down close to a third, with no fees or errors involved.
• Money tends to arrive after good stretches, because that is when a holding is visible, and to leave in bad ones, because that is when cash is needed.
• The arrangements that narrow the gap work by moving the decision away from the moment, not by demanding more discipline.