Investors and their financial advisors commonly assume that adopting a consistent investment approach involving regular contributions and dollar-cost averaging will result in better long-term outcomes. Similarly, they often believe that opting for the lowest-cost funds will yield similar benefits. However, recent research released by Morningstar challenges these widely accepted investment practices, revealing that they don’t necessarily lead to superior returns. Although these approaches may be somewhat helpful, they can lead to classic investment mistakes that ultimately harm investors’ portfolios.
During a recent webinar, Jeff Ptak, the Chief Ratings Officer at Morningstar, explained that investors should not automatically expect “mere penny-pinching or indexing” to directly translate into higher dollar-weighted returns. While minimizing costs and passively investing through diversified index funds or ETFs are commendable strategies, they do not consistently prevent significant differences between these funds’ dollar-weighted and total returns.
Ptak referred to “total returns” as the returns an investment fund or strategy would generate if fully funded upfront, left to mature throughout the investment period without additional trades or contributions. The research indicates that even investors who emphasize low costs and a passive approach can face timing-related challenges. Some of this can be attributed to circumstances, such as investing in low-cost passive funds over time as part of a long-term plan, only to witness deteriorating returns.
Ptak acknowledged that while a contribution-based approach should not be abandoned due to its practicality and merits, advisors and their clients must remain cautious about the potential negative impact of poorly timed purchases and sales of fund shares on their returns.
The Drawback of Dollar-Cost Averaging
According to Morningstar’s study, dollar-weighted returns, also known as investor returns, averaged around 6% per year for the typical dollar invested in mutual funds and exchange-traded funds over the trailing ten years ending on December 31, 2024. This figure falls about 1.7 percentage points short of the total returns generated by the fund investments during the same period. This shortfall termed the “return gap,” primarily results from poorly timed transactions involving the purchase and sale of fund shares.
The timing issue causes investors to miss out on approximately one-fifth of the return they would have earned had they simply bought and held their investments. Ptak’s analysis emphasizes that this performance gap seems almost inevitable for investors who gradually invest in a fund over time. If investments flow into a fund before returns surge, dollar-weighted returns improve; conversely, the opposite occurs if there’s an outflow before returns increase.
Ptak noted that investors often chase high-performing funds while avoiding low-performing ones. Consistently buying high and selling low over time creates a pattern of behavior that ultimately results in lower returns. He suggested that investors had better success when they favored simpler solutions like the allocation of funds rather than aiming for perfection.
Interestingly, the research revealed more significant return gaps in areas supported by robust academic evidence, such as value-oriented strategies, small-company stocks, or emerging markets. Ptak argued that this implies the added volatility of these strategies erodes any potential excess returns and even results in losses. This holds for more complex strategies that might seem promising on paper but end up causing costly mistakes for investors.
Recommended Behaviors
The research also advocates for investors to hold a smaller number of widely diversified funds and engage in periodic rebalancing based on the actual performance of different portfolio segments. Morningstar consistently finds that investors in allocation funds capture a larger share of the fund’s total returns. These funds are designed as comprehensive holdings spanning multiple asset classes, and they automatically rebalance at regular intervals, sparing investors the need for extensive portfolio management.
Allocation of funds also helps mitigate the risk of “mental accounting mistakes,” where investors make inappropriate buying and selling decisions based on the performance of individual strategies. Ptak highlighted the importance of avoiding narrow or highly volatile funds despite their seemingly appealing potential returns. He cautioned that investors have struggled to effectively utilize such specialized or volatile funds, often exhibiting some of the most significant return gaps.
Ptak recommends adopting a simplified approach that emphasizes wide diversification and low costs for most investors. This involves steering clear of complex strategies that could lead to undesirable outcomes.