Why Average Investors Don’t Make Average Returns

It’s a common misconception that average investors will earn an average rate of return. Unfortunately, the reality is far from this ideal. Multiple factors contribute to the disconnect between the expected return and the actual return that the average investor achieves. The average market return can be achieved by investing in passive index funds. Surprisingly, the returns of simply “buying the whole market” will outperform most investors who pick their own investments. Here’s why:

Fees

Investment Management Fees & Transaction Costs: Many investors are not paying close enough attention to the fees associated with their investment accounts. Especially investment management fees. These fees, no matter how small they may seem initially, add up over time and eat into returns.

Wealthy investors should try to reduce their investment management fees. Its common for investors to be paying investment management fees of 0.50% to 1% per year (or more if they use private equity funds). This means annual fees of $50,000 to $100,000 per year on accounts worth $10 million. Even if a portion of such a portfolio were shifted to index funds, the savings would be hundreds of thousands of dollars!

Active vs. Passive: Actively managed funds, where fund managers pick and choose investments, generally charge higher fees than passive funds, which simply track an index. The irony is that many actively managed funds also fail to beat their benchmark indexes, meaning investors are paying more for underperformance.

Taxes

Capital Gains: Many investment advisors suggest that we re-balance our portfolio regularly. The sales pitch is this will help us manage risk. But, the problem is such re-balancing also triggers capital gains taxes. And this will be a big drag on returns. Because each time a profitable investment is sold, the CRA takes their share.

Tax-inefficient strategies: Simple buy-and-hold strategies avoid triggering capital gains taxes and instead let returns compound tax free.

Psychology

Emotional Investing: One of the most significant challenges investors face is their own behavior. Panic selling during market downturns or chasing the latest “hot stock” often results in buying high and selling low, the exact opposite of what is desired.

Overconfidence: Believing that one can outsmart the market consistently can lead to frequent trading and, as a result, higher transaction costs and taxes.

Cash

Overemphasis on Liquidity: Holding a significant portion of an investment portfolio in cash can drag down overall returns, especially in low-interest-rate environments. While it’s important to have liquidity for emergencies, an excessive cash position can hinder portfolio growth.

Index Funds are the Solution?

While the allure of outperforming the market is tempting, the reality often falls short due to overlooked fees, tax implications, and emotional investing behaviors. For the average investor, the simplicity, cost-effectiveness, and tax efficiency of index funds often lead to more consistent and potentially higher returns over time. Instead of trying to beat the market, sometimes the wisest approach is to simply be a part of it.