Expert POV: Why so Many Investors Lose Out When They Chase Gains

If index funds are the closest to a sure thing in today's stock market, why do so many investors fall short? I suspect you’ve already heard my spiel on index fund investing, so I thought some insights from a more learned individual’s slant on the matter might be instructive. One of Wall Street’s most prominent journalists, Jason Zweig, pens "The Intelligent Investor" column weekly for The Wall Street Journal.

A recently published article of his sheds light on why so many conservative investors can’t leave well enough alone while utilizing one of the best tools in today’s investment world. I'll add my two cents here and there. And, in the video above, Zweig gives a Google Talk on his book, The Devil's Financial Dictionary, in which he distills everything he learned in his decades-long investing journalist career.

Traders' Temptation

Index funds have made investing simple – but not easy. Portfolios that seek to match rather than beat a market’s returns usually charge extremely low fees and generate low tax bills. If you buy a handful of index funds, sit on them for decades and never do another thing, you’re likely to outperform nearly everyone who tries to beat the market by trading—including most professionals...Can you endure a lifetime of barbecues and cocktail parties where other people brag about their winning trades and all you can do is mutter, ‘Umm, I own index funds, and I haven’t made a trade in a decade? No wonder index funds can become tempting to trade.' ----- Zweig

This is good stuff but nothing new here, in my opinion.

Still, why do so many conservative investors persist in their efforts to make a sure thing less certain? In short, if an individual invests in an S&P 500 or Total Stock Market Index Fund that virtually assures a market match, why tinker with it? Still, as the 16th century poet, Alexander Pope, famously stated, “To err is human.”

Highs and Lows

Each year, the research firm (Morningstar) estimates the gap between the returns of mutual funds and exchange-traded funds and the returns their investors earn as a group. Mutual fund or ETF returns are reported as if you bought at the beginning of a measurement period, reinvested all income or capital gains, and never cashed out. After all, that’s how the fund, as an investment, behaved. But it isn’t how most of its investors behaved. Some bought and held fast. Others traded fast, driven either by financial circumstances or their own fickle emotions. Morningstar estimates a separate figure—investor returns—by accounting for the money a fund’s owners collectively added and pulled out during the period. Those who buy and hold will earn investor returns close to their funds’ reported total returns. Those who buy high and sell low will earn investor returns lower than those of the funds they own. ----- Zweig

According to Zweig, over the decade ended Dec. 31, 2023, Morningstar found that investors in the aggregate earned an average of 6.3% annually, or 1.1 percentage points less than the mutual funds and ETFs they owned. He writes that a small gap is almost inevitable and over most periods of 10 years or more, stocks go up.

Contributing gradually—say, through your 401(k)—means you’ll lag your fund in the long run, simply because you didn’t put all your money to work in the beginning. That’s true even if you’re purely a buy-and-hold investor who never chases hot returns or panic-sells in market crashes. ----- Zweig

A Sure Thing

Vanguard’s John Bogle certainly didn’t have trading (tinkering, if you will) in mind back in the 1970s when he introduced index funds to the small investor. And as I’ve emphasized many times, utilizing the index fund approach is the stock market’s closest to a sure thing. By definition it’s a process that virtually assures an investor of matching the market’s yield. So why screw it up by injecting a trader’s mentality into the process?

Just understand that if you do, you’ll end up being one of those “so-called” index fund investors that falls short of your objective…matching the market.

Too many investors aren’t patient, however, and often bet on narrower slices of the market. Because index funds are cheaper and diverge less from their benchmarks than actively managed funds do, they’ve become the vehicle of choice for these short-term bets. ----- Zweig 

Get Rich Quick-ness

Zweig writes that sector funds, as opposed to funds that track the whole market, is an area where wrong-footed trades can quickly push investor returns far below the funds’ own returns.

Portfolios of stocks in specific industries like technology or energy…where every bit of noise feels like news… can goad people into trying to get rich quick. Among these specialized industry portfolios, a lot more money sloshes in and out of index funds than at their actively managed peers. If they buy high and sell low, investors can underperform the funds they invest in. In portfolios ​investing in a single industry, that happens even at market-matching index funds, where short-​term volatility can drive investors in and out quickly. ----- Zweig

According to Zweig, over the 10 years ended December 31, 2023, investor returns fell behind total returns at sector index funds by 2.9 percentage points annually—even worse than the 2.0-point gap at actively managed sector portfolios.

When you shoot for the moon with sector index funds, you stand a good chance of shooting yourself in the foot. ----- Zweig

In Sum

To summarize Zweig’s informative perspective of why so many index fund owners fail to match the market, he asks and answers the question: How can you narrow the performance gap between you and your fund?

First, remember that index funds aren’t safe. They’re just cheap. You can burn yourself as badly playing with matches as you can with a fancy lighter. Stick to the broadest possible index funds for nearly all your money. The narrower the benchmark the fund tracks, the more it will fluctuate and the more likely you are to get spooked out of it at just the wrong time. If you feel you must make a bet, limit it to a tiny part of your portfolio…5%, max. Don’t add to it, no matter what…especially if you make money. Chasing gains is the best way to end up capturing losses. ----- Zweig