Many new investors face a loss not because they chose the incorrect fund, instead, they weren’t able to trust the good one. We have more than enough evidence to prove this fact and it sure is disconcerting. An average investor gains about half of the market’s return and these returns are not at all related to the choice of the fund. They are all based on the investor’s behavior. Selling in panic, following popular trends, unnecessarily making changes in a well-established portfolio, these are the real costs and they overweight the cost of the expense ratio by far.
The behavior gap is bigger than the skill gap
DALBAR’s Quantitative Analysis of Investor Behavior has been monitoring this for decades. Over 20-year timeframes, the typical equity mutual fund investor earns roughly 5% annually, compared to around 10% for the S&P 500 index during the same period. This represents a significant difference. It could be the distinction between a portfolio that helps you enjoy a comfortable retirement and one that leaves you well short of your goals.
The issue is not poor investment selection as most individuals would expect. Rather, people tend to buy shares after they have increased in price, as they fear they might otherwise miss out on potential gains. Then they sell as share prices drop because they cannot tolerate the declining value of their investment. They enter the market late and leave early, repeatedly doing so, and each time their actions reduce the return they could earn if they just had a better understanding of simple investing, and when to actually act on market changes.
What is particularly difficult to digest is that in most cases, the plan or strategy would have worked. It is the investor’s implementation of the plan/strategy that is flawed.
Complexity is a product, and it’s being sold to you
Leveraged ETFs, options strategies, thematic stock baskets, cryptocurrency – these aren’t neutral tools sitting on a shelf waiting to be used correctly. They’re products, and complexity is part of what’s being sold. More moving parts means more fees, wider spreads, and more decisions to get wrong.
A leveraged ETF doesn’t just double your returns on a good day. It also doubles your losses on a bad one, and the daily rebalancing mechanics mean it can bleed value even when the underlying asset is roughly flat over time. Options require you to be right about direction, magnitude, and timing all at once. Thematic stock picks demand you correctly identify not just a good trend but the specific company that will win from it, years before the outcome is obvious.
None of this is impossible to manage. But it requires time, attention, and emotional discipline that most beginners simply don’t have available, because they have jobs and families and lives that don’t revolve around checking a portfolio three times a day. The tools aren’t broken. They’re just built for a level of engagement most people can’t sustain for the 20 or 30 years investing actually requires.
Overtrading charges you three times
Whenever you make a purchase or sale, you are paying a type of tax, and there are three tiers to it.
Firstly, there is the direct trading expense. For even “commission-free” trades, the spread is often wider than you would see for a buy-and-hold investment. Secondly, frequent trading results in capital gains taxes due to the less favorable rates on short-term holdings. Finally, the worst part, is the mental tax: overtrading is the result of trying to predict the market and making those decisions under pressure. You end up buying high and then selling low, which is the exact opposite of what you should be doing to make money.
Trading gives the illusion of success, but in reality, a constantly traded account will perform worse than one that is not tampered with.
The professionals don’t beat the market either
If excessive trading and stock-picking were effective strategies, one would assume that professional fund managers – those who spend all their time doing this, with the support of whole research teams and expensive data terminals – would reliably beat a straightforward benchmark. But they don’t.
The SPIVA scorecard is a regularly published league table that summarises how active picks do versus simple benchmark indices, across rolling timeframes. The results vary, but it is always the case that the overwhelming majority of active managers fail to clear the low, low bar of beating their index over a 10-year period. Not most years. Most managers, most of the time, long-term.
This matters for the total beginner thinking about how to invest, because you can’t fall back on the excuse that “I’m not good enough to pick shares, but a pro would”. A pro wouldn’t, at least not on average. And you’d be paying them a neat fee for the privilege of underperformance. This was arguably made more famous by Warren Buffett’s public decade-long example, where he bet that a low-cost S&P 500 index fund would beat a spread of hedge funds managed by some of the brightest people in finance. The index fund won, with room to spare, over the subsequent 10 years. Simple beat clever among the very most sophisticated players in the world, not just in the investment amateurs’ market.
Fees are a silent, compounding cost
The impact of expense ratios might not be obvious to many investors at first. The annual fees you pay to own a fund are not taken out of your account and mailed to the adviser you never met. The costs, and the returns, are simply netted from the fund’s underlying performance. But those deductions accrue and make a real, predictable difference in long-term results.
Yet, the financial industry’s game of plausible deniability on the issue persists. Surrendering an extra 1% or more of your annual earnings to the financial institution that built and marketed the product might be costing you more than you think. Take a £10,000 investment held for 30 years. A 1% annual difference in fees – not an unusual gap between an actively managed fund and a low-cost index fund – can reduce the final portfolio value by somewhere in the region of £10,000 to £15,000, depending on the assumed rate of return. That’s not a rounding error. You should care, because it’s your money – and it’s certain that no one else will care as much about it as you do.
The fix is boring, and that’s the point
This is where the rubber hits the road. And the best response to all of this is not a more sophisticated stock selection approach or a better market timing technique. It’s making fewer decisions, minimizing costs, and reducing activity. This is the essence of simple investing: establish a sound allocation, automate the contributions, and leave it alone.
You begin with asset allocation – stocks versus bonds – because it exerts the greatest influence on your portfolio’s risk and return over time, much more than the specific index fund you pick. Your allocation needs to reflect your risk tolerance, i.e., how much volatility you can actually endure before you panic and sell, not how much you think should be fine with you.
Then, dollar-cost averaging takes over. Investing a fixed amount on a regular basis insulates you from the timing decision since you’re not reacting to the week’s market gyrations. You end up buying more shares when prices are low and fewer when prices are high. Predictably. Automatically.
And, you only have to make one decision annually: whether to rebalance your portfolio or not. That’s all. One decision point for the year with this kind of a portfolio. It’s not an ongoing cascade of decisions that you have to make – over and over again. What to buy, sell, or do nothing. One. And only one.
One-product solutions exist for a reason
For those who prefer to have even fewer decisions to make, target-date funds are a set-it-and-forget-it option that makes the gradual allocation shift from stocks to bonds for you as you near your target retirement date. Multi-asset “one-fund” solutions do this, as well, but bundle the stock/bond mix into a single holding. And then robo-advisors take total control, constructing the portfolio and making any needed changes according to your risk profile – all out of your hands.
The above are not solutions for people who can’t handle investing. They’re all “pro” allocation strategies – ones that help manage risk by spreading your money across a range of assets – packaged in easy-to-digest forms that help take the urge to tweak things out of the equation. The urge to tweak is the problem – removing it is the feature.
Simple portfolios survive; complicated ones get abandoned
A diversified portfolio is effective only if you can maintain it even when it performs poorly, and this is where a simple strategy really proves its worth. For instance, a ten-fund portfolio packed with duplicate assets, leveraged products, and risky wagers is difficult to comprehend and hard to rationalize when things are going south. Consequently, it is easy to get rid of because you’re not fully aware of what you’ve invested in or the reasons behind it.
On the other hand, a portfolio constructed from two or three low-cost index funds, with automated contributions and an annual re-balance, is easy to stick with precisely because it’s easy to understand. You know its purpose. You understand why it dips during the bad times. This level of clarity is what drives people to stay invested during these critical periods and ensures they won’t abandon their strategy.
Compound interest requires time to yield results, and time can only help you if you remain in the game. It is highly probable that the investor who holds onto a simple index portfolio for 30 years and doesn’t panic will perform better than the investor who constructs something elaborate and keeps tweaking it.
The most effective investment approach is the one you can follow for decades without fretting about it. This doesn’t mean you’re compromising. It is exactly what a sound investment plan should be: automatic, diversified, low-cost, and left alone to accomplish its purpose.
