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Beating the market is hard, but beating the average dollar invested in the market is relatively easy if you can avoid making one common mistake.

Investors often find their picks underperform because they are chasing past performance; they are remarkably consistent with their propensity to get into an investment after it has done well, and then get out after it has done poorly.

The result is a sizable gap between the returns that stock indexes and mutual funds deliver, and the returns that investors actually get. Investors will typically have underperformed the fund or asset class they are investing in, and often by a lot.

(This gap can be estimated by comparing the time-weighted returns of a fund or asset class – a calculation method which ignores the timing of contributions and withdrawals – to the money-weighted returns of the investors in that fund or asset class – a calculation methodology which reflects the impact of contribution and withdrawal timing.)

Performance-chasing is a persistent feature of financial markets. It explains aggregate flows to mutual funds and the flows across funds, and it holds for both actively managed and index funds. The resulting performance gap is at least 1.5 to 2 percentage points, depending on the source data, and it tends to be much larger for more volatile, specialized and speculative funds.

Canada’s mutual fund fees, which currently sit just under 2 per cent on average, rightfully get a lot of attention, but these data suggest that investors’ return-chasing tendencies may be costing them at least as much in foregone returns.

The data on investors’ timing, and the impact of their timing on performance, should not be too surprising given the well-documented relationship between expected returns and subjective return expectations.

Expected returns can be estimated using valuation metrics like the Shiller cyclically adjusted price earnings ratio, while return expectations are the subjective estimates that investors hold for future returns.

The problem is that investors tend to have low subjective return expectations when expected returns are high, and high subjective return expectations when expected returns are low.

They will be more likely to believe that a fund with strong recent returns and, correspondingly, holdings likely to have high valuations, will also have strong future returns, and that a fund that has done poorly will continue to do so. There is a good chance that this will be an error.

The returns of diversified portfolios are largely explained by their exposure to certain types of stocks. When a fund’s style exposures have a period of poor performance, the fund’s return correspondingly falls, driving investors away, and pushing down the valuation of the fund’s style.

The same effect works in the other direction, too. A fund with strong recent past performance, which probably looks enticing to investors, is likely exposed to a style that has recently done well, resulting in higher valuations, and lower expected returns.

Timing errors occur both on the upside, buying after recent positive past performance, and on the downside, selling after a decline, but selling after a decline seems to contribute more to the overall performance gap.

These data highlight the importance of having a portfolio, and an investment strategy more generally, that you can stick with. Exciting funds and asset classes will come and go over time, and every investment strategy will experience declines.

Success in investing is less about trying to get the timing right, and more about minimizing the opportunities to get the timing wrong. Stock markets have delivered incredible returns. To capture them successfully, the biggest hurdle for most people is their own behavior.

Benjamin Felix is a portfolio manager and head of research at PWL Capital. He co-hosts the Rational Reminder podcast and has a YouTube channel. He is a CFP® professional and a CFA® charterholder.

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