Every year, fresh data emerges, painting the financial habits of investors in an ever-clearer light and each year a consistent trend appears: the average investor’s return lags that of the total return of the funds they are invested in. Why does this happen, and could 401(k) plans be the answer to closing this gap?
The Gap Between Investors and Mutual Funds
Morningstar’s “Mind the Gap” report states:
“Fund investors earned a 6% investor return over the 10 years ended Dec. 31, 2022, while their fund holdings generated a 7.7% annual total return over the same period. Thus, investors suffered a 1.7 percentage point annual return shortfall, or gap, stemming from mistimed purchases and sales.”
Simply put, this roughly 2% gap is largely due to the timing of the investor’s cash flows into and out of the fund.
The Morningstar report also goes on to say that the annual return gap is consistent with the gaps measured over the previous rolling 10-year periods.
More proof of the gap in performance comes from Dalbar’s Quantitative Analysis of Investor Behavior (QAIB). The study uses mutual fund sales, exchanges, and redemption data each month to measure investor behavior. For the period ending December 31, 2021, the average equity fund investor:
“Finished the year with a return of 18.39% versus an S&P 500 return of 28.71%; an investor return gap of 10.32% – the third largest annual gap since 1985, when QAIB analysis began.”
The performance gap between the average investor and mutual funds underscores the importance of strategy and discipline in investing. While it’s tempting to think we can time the market, evidence suggests otherwise. 401(k) plans could be an effective way to bridge the performance gap because employer-sponsored retirement plans have features that inherently counteract some of the common pitfalls of the average investor.
The Power of 401(k) Plans
The investment landscape has evolved over the years and with the rise of 401(k) retirement plans, a substantial percentage of working Americans have harnessed the power of these plans to grow their retirement nest egg. Recent data and research from the Investment Company Institute (ICI) indicate that investors who participate in 401(k) plans tend to have more favorable investment outcomes compared to the average investor. Let’s explore some reasons why:
Automatic Contributions & Dollar-Cost Averaging
One of the cornerstones of a 401(k) plan is the automatic contribution feature, which allows employees to set aside a portion of their salary into their retirement account. This translates into consistent investments irrespective of market conditions. By investing at regular intervals, participants naturally engage in dollar-cost averaging. This strategy means they buy more shares when prices are low and fewer shares when prices are high. Over time, this can lead to a lower average cost per share, which can enhance potential returns.
Professionally Managed Investment Options
401(k) plans often come with a curated selection of mutual funds and other investment options managed by professionals. These funds are selected after thorough vetting by plan providers and are monitored regularly for performance and risk. The average investor, on the other hand, may not always have access to such rigorously vetted options.
Diversification
401(k) plans often offer a broad range of investment options, which allows participants to diversify their holdings. Diversification is a fundamental investment principle that can reduce risk. The average investor might not diversify their portfolio as effectively without the guidance or constraints of a 401(k) plan.
Employer Match
Many employers offer a matching contribution up to a certain percentage of the employee’s salary. This is essentially “free money” and provides an immediate return on the employee’s contribution. This match not only boosts the savings rate but also encourages consistent participation.
Automatic Enrollment and Escalation
Many employers have adopted automatic enrollment for their employees, which means they start contributing to their 401(k) by default unless they opt-out. Additionally, some plans include automatic escalation, which gradually increases the percentage of salary contributions over time. Both these features encourage savings and participation.
Educational Resources
401(k) plan providers often furnish participants with educational materials, tools, and resources. This education can enhance financial literacy, helping participants make more informed decisions.
Long-Term Investment Horizon
With penalties for early withdrawals and a primary goal of retirement savings, 401(k) participants are encouraged to adopt a long-term perspective. This reduces the temptation to engage in frequent trading or chase the latest investment fads, which can erode returns.
Lower Fees Through Institutional Pricing
Owing to the collective buying power of many participants in a plan, 401(k)s often secure institutional pricing for their investment options. This means lower fees and expenses compared to retail investment products, leading to better net returns for participants.
Conclusion
While investing always carries inherent risks, the structure and design of 401(k) plans inherently encourage behaviors that promote better investment outcomes. The combination of automatic contributions, professionally managed funds, a long-term horizon, lower fees, and limited market timing could make a significant difference over an investor’s lifetime.
The opinions and commentary of the author are provided for general and educational purposes only and are not intended to provide legal, tax, or investment advice.
Information is as of the date published and may not contain updates or changes to the topics covered.
This information is not intended to reflect a current or past recommendation concerning investments, investment strategies, or account types; advice of any kind; or a solicitation of an offer to buy or sell any securities or investment services.
Wyatt Moerdyk is the CCO, and Managing Member of Evidence Advisors, LLC, a registered investment advisory firm.
References:
- Investment Company Institute. (2022). The Role of IRAs in US Households’ Saving for Retirement, 2022. Washington, DC: Investment Company Institute.
- DALBAR, Inc. (2021). Quantitative Analysis of Investor Behavior, 2021. Boston, MA: DALBAR.
- “Mind the Gap Report”, Morningstar, (2023)
