The Biggest Cost of Investing

“In one large-scale experiment,” writes Ethan Cross, “a group of scientists gave people a choice: do nothing and have a 10% chance of dying from cancer, or undergo a novel treatment that has a 5% chance of killing you.”

Obviously the second option is better—a 10% chance of dying is worse than 5%; yet when scientists polled a large group of people as part of an experiment, 40% of participants chose the first option*.

There are a number of possible reasons for this head-scratching outcome.  One might be that we’re not very good with numbers (true). Another might be that, under stressful situations, especially ones related to our heath or wellbeing, we have a tendency to not make good decisions (also true).  Whatever the actual reason, the study’s relevance to this article is that I see mistakes like this every day from individual investors (and some financial advisors), and these all-too-common mistakes add up to the biggest actual cost of investing.  Not commissions, not expense ratios, not the average financial advisor’s fees.  

Bad behavior is the biggest cost of investing.

That’s a bold claim, but the evidence on this is pretty clear.  Bad investing behavior—buying and selling at the wrong time, more specifically panicking in bad times or chasing performance in good times, making reactionary changes based on a cursory review of the financial headlines—whatever the cause, it really adds up.  

To how much?  

Investment analysis firm Morningstar studies this as closely as anyone and produces an annual survey in which they report the difference between the returns earned by mutual funds and the average investor’s returns in those mutual funds.  The results of their latest study, published late last year, can be seen below.

Morningstar looked at a variety of different investment categories from US and international stocks to bonds and asset allocation funds. On average, individual investors across all of these funds underperformed the funds they held by 1.68% per year.  Let’s call it 1.7%.  Not a single category was positive.  Wow.

Just how much is this for a wealthy investor?  Imagine you started ten years ago with $1,000,000 and invested in the DFA Equity Balanced Strategy Portfolio.  Ignoring any other fees but fund expenses, the portfolio would have grown to $3,212,559.  But if you simply behaved liked the average investor and failed to stick with your portfolio, instead buying and selling at the wrong time and costing yourself 1.7% per year, your ending amount would have only been $2,711,875, or $500,683 less than you should have had!  In just 10 years, bad behavior cost you over 50% of your starting portfolio value!  

See what I mean by costs?

Obviously, you should do whatever is necessary to not to pay the behavioral costs of investing.  You should avoid the things the average investor does (which I’ll try to summarize in a future article) to penalize themselves by almost -2% per year, causing them to have far less wealth over time than they deserve.  Or as I often tell prospective clients who have done a good job saving and should be able to comfortably reach their financial goals: Your only job now is to not screw this up.  Too blunt? Maybe. But I have found it’s effective.

Of course, no one thinks they’ll screw it up.  That’s only other people who behave poorly.  You’re probably thinking this right now.  But studies on decision making reliably find that in fact we do make mistakes, we just can’t recognize them.  And by “we,” I mean you.

Back to the study at the beginning of the article, for which there was a second part.  This time, instead of asking volunteers which approach they would take after learning of the hypothetical diagnosis, the organizers of the study asked the same group of people to make the decision on behalf of someone else.  The result?  31% made the wrong choice.  Now, 31% is still shockingly high, yes, but compared to 40%, the wrong decision happened 23% less than when participants made a decision for someone else versus for themselves.  Same decision, different perspective, major improvement.

The lesson?  While we often have blind spots when it comes to making decisions for ourselves, these blind spots tend to decrease or disappear when we’re advising someone else on the same topic. 

We can see direct evidence of this conclusion from the table above. The row with the smallest behavior gap is the “Allocation” category, which includes balanced stock and bond portfolios and Target Date Funds.  These strategies ask you only to pick your year of planned retirement; the investment choices are then made for you.  In essence, with these funds, you’re letting someone else tell you what to do after providing a basic input like your planned retirement year.  You aren’t forced to create your own asset allocation and manage it through thick and thin.  This approach, where investors were simply following the generic advice of someone else, worked out far better. The behavior gap of just -0.7% per year for this “guided” approach is a 1% savings compared to the average investor left to their own devices.

But is there a way to shave even more off the behavior gap?  I think there is.

Instead of managing your own money and making all your own decisions, or accepting generic advice, you could hire a financial advisor who would develop a personalized plan for you based on your specific goals and manage a portfolio that is consistent with your plan.  If that advisor also served as a “behavioral coach,” working with you on an ongoing basis and advising you not to sell at the wrong time or chase the performance of a hot asset class you don’t own (or own too little of), and you simply accepted that advice, you would save yourself much, if not all of the cost of bad behavior.

Now, I admit that this may sound like self-serving advice from a professional full-time financial advisor.  The burden of proof should be on me to support my claim.  Fortunately there is solid evidence that advisors like Servo, who manage long-term “asset class” investment portfolios and promote the importance of staying disciplined, have had considerable success in helping clients earn the full returns of the portfolios they own, and in some cases more.  So don’t just take my word for it.

The table below is from a study Morningstar conducted years ago that compared the dollar-weighted (DWR) returns of DFA Funds—available only to indendependent financial advisors and their clients—to their time-weighted (TR) returns, and then the same calculation for all index funds.  Their findings:

“Advisors who use DFA encourage very smart behavior among their clients, even buying more out-of-favor segments of the market and riding them up, rather than buying at the peak and riding the trend down, which is usually the case with fund investors.”

Quite simply, more help from a professional advisor meant more disciplined investors. Not just an elimination of a negative behavior gap, but a positive gap! Investors wound up doing even better—+0.9% per year!—than the funds they owned (because they sold them/rebalanced when they were doing their best and bought them when they were most out of favor).  

Interestingly, this study covered a different period of time than the first one I cited but the behavior gap found from regular index fund investors of -1.6% per year was almost identical to the behavior gap cited above; past performance is not guaranteed, but past (bad) behavior seems like a sure bet.

As Nick Murray is fond of saying: Human nature is a failed investor.

Now, a financial advisor is not free.  While the typical full-time advisor (including Servo) charges 1% per year on the assets we manage (0.50% on amounts over $2M and 0.25% on amounts over $10M), investors need to weigh that cost with the probability that, without the advisor, they would achieve the results of the average investor and lose closer to 2% per year in behavioral costs.  This is not to imply that the only benefit to hiring a full-time financial advisor is to keep you disciplined, and I’ll spend a future article covering some of the other commonly-cited advantages.  But if an investor rationally views themselves as average, then the math works out—1% per year is just two-thirds of 1.7% per year.

You could, instead, look for professional advice that costs less.  That way, you could potentially be talked out of the moves that might cost you -1.7% per year, without having to pay 1% for the service (again, ignoring for now the other advisor benefits).

There are advisors who charge you for a one-time plan and then expect you to implement and manage it on your own; but of course that won’t solve the behavioral dilemma—it’s just self-directed investing with an initial nudge.  

What about cheaper ongoing advice?  Maybe, unlike every other aspect of life where we’ve learned that “you get what you pay for,” investing advice is different?  Maybe you could pay a reduced fee and get the same (or better?!?) advice?  Consider me skeptical.  I see many financial firms trying to compete on price, which I fully support—competition in all realms leads to better choices for consumers.  What I don’t see is better advice emanating from these cheaper firms.  In short: you can have cheaper advice, or you can get better advice.  You can’t have both.

Consider the updated investment advice from prominent “robo-advisor” Wealthfront, who manages portfolios of exchange-traded-funds for clients (at a fee below 1%) after they complete an online questionnaire about their goals and risk tolerance.  For years, Wealthfront maintained allocations that were globally diversified and, in line with reams of academic research, tilted to small cap and value stocks.  Until recently.  

The poor recent returns from value stocks—which have pushed their prices versus fundamentals to depths never seen before compared to growth stocks (read: better potential future returns than ever before)—has led Wealthfront to abandon them!  At maybe the best time ever to be a value investor, they’ve given up on value investing and sold their value funds from client portfolios!

What are they doing instead? They’re adding a different factor tilt: Profitability.  There’s nothing wrong with emphasizing stocks with higher overall profitability, it’s a legitamite return factor that has been studied most closely by Robert Novy-Marx (who works with Dimensional Fund Advisors when not teaching at the University of Rochester in Upstate NY) and that we have for years included in our portfolios.  

But profitability has done much better in recent years and over the last decade, and now high profitability stock prices are relatively higher (read: future expected premiums are lower).  Novy-Marx has said repeatedly that profitability should not be pursued by itself, but as a compliment to an existing allocation to lower-priced value stocks.  Profitability and value are better together than by themselves, and yet Wealthfront apparently didn’t get the memo (or read the academic studies).

Even if you don’t follow the specifics, what I have described generally is a textbook case of how you might manage to lose 1.7% per year of an investment portfolio to bad behavior: buy high, sell low, read too much into recent returns, and miss out on an extraordinary potential return after suffering through poor recent performance that created the opportunity.  Except for clients of Wealthfront looking to save a few bucks in advisory fees, they’re paying an additional cost to do what they’d mostly likely manage to do just as well on their own!

Investors in recent years have adopted an ever-increasing amount of fee sensitivity.  I have seen on many occasions press releases cheered for announcing index funds that are cutting their expense ratios by 0.01% or 0.03%—an amount that will never make even the slightest difference to long-term investors of even substantial means. I’ve heard investors (and some advisors who exclusively market their lower fees) suggest that hiring a full-time advisor, and paying the typical 1% per year fee, is crazy.  Many people believe that if you do not keep your expense ratios to the absolute minimum, or reduce/eliminate advisory fees, you’re unlikely to be successful financially.  I strongly disagree.

The decisions investors makewhat they buy/sell, and when they buy and sell it, logically is the biggest determinate of an investor’s long-term success.  It’s simple math that if the average investor loses 1.7% per year from bad decision making, this avoidable expense exceeds the cost of hiring a full time advisor and/or any slightly higher expense ratios (that typically come from owning asset classes, such as small cap value stocks, with much higher expected returns).  

This should be good news for all investors.  Your outcomes are within your control, not the whims of the market or your ability to find the absolute lowest cost investments or advice available.  You have very good options should you decide that bad behavior has been or is likely to be a potential significant cost for you—you can get ongoing help and advice that may cost you a lot of money when looked at in isolation but in reality is far less than what you’d “pay” without it.

If you’d like to chat about the investment mistakes you have made or could see yourself making in the future, and ways that you might avoid them and potentially achieve a better investment and wealth experience, click the link here to schedule 15 minutes to talk with me about your personal situation.


*Ethan KrossChatter: The Voice in Our Head, Why It Matters, and How to Harness It. Pg. 58.

Past performance is not a guarantee of future results. Index and mutual fund performance includes reinvestment of dividends and other earnings but does not reflect the deduction of investment advisory fees or other expenses except where noted. This content is provided for informational purposes and should not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services.