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Portfolio > Mutual Funds

Why 'Buy and Hold' Works Better for Investors: Morningstar

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What You Need to Know

  • Gaps in personal versus fund returns are typical; how and when clients invest can make a difference.
  • Clients can take steps to improve their odds.
  • Investing in index funds didn’t necessarily erase performance gaps, according to Morningstar.

The time-tested advice that clients buy and hold and avoid trying to time the market has received a boost from a Morningstar study, which found investors’ total annual returns came in roughly 1.7 percentage points lower than returns for the mutual funds and ETFs they owned.

The research firm’s annual “Mind the Gap” report found the average dollar invested in funds earned investors a 6% annual return over the 10 year-period that ended Dec. 31, 2022, compared with roughly 7.7% returns for the funds.

“This shortfall, or gap, stems from poorly timed purchases and sales of fund shares, which cost investors roughly one fifth the return they would have earned if they had simply bought and held,” the report from Jeffrey Ptak, Morningstar chief ratings officer, Amy Arnott, portfolio strategist and others said.

The gap is in line with the firm’s findings for four previous rolling 10-year results.

The two largest fund types by net assets — U.S. equity funds and taxable-bond funds — had smaller return gaps than the fund universe as a whole, and investors in funds that combine stocks, bonds and other asset classes “have continued to fare best, as these funds had the narrowest return gap of any category group,” Morningstar said.

Gaps for sector and nontraditional equity funds were wider than average, and more volatile funds tended to experience wider gaps, the report said.

The relationship between return gaps and fund fees was less clear, since gaps for the cheapest funds were similar to those for the category groups as a whole, Morningstar reported.

Why the Gap?

“Most reported total returns are time-weighted, meaning they assume a lump-sum investment made at the beginning of the measurement term that’s held throughout the whole period to the end. But investor returns can be a more telling measure because they include the impact of cash inflows and outflows,” the report said.

“Investor returns are essentially an internal rate-of-return calculation that accounts for periods when investors have more dollars invested, which will carry more weight in their overall results,” it noted, adding that investor returns will almost always differ from reported total returns.

Attempts to time the market aren’t solely responsible for the performance gaps, Morningstar suggested.

“Bad decisions such as trading too often, buying funds after they’ve already run up, and selling in a panic after market declines can all chip away at investor returns. But even perfectly reasonable approaches to managing a portfolio — such as investing a portion of every paycheck or shifting more assets toward fixed income as you approach retirement — can open a gap between investor results and reported total returns,” the firm said.

“Investor returns will never perfectly match total returns because few investors can simply buy and hold over every time period. But the negative return gaps for the majority of investor dollars suggest there’s still room for improvement. Investors can increase their odds of success by taking a more disciplined  approach and trying to avoid some of the most common pitfalls, such as buying high and selling low.”

Suggestion to Narrow the Gap: Keep It Simple

Because market returns are positive more often than not, dollar-cost averaging often leads to lower returns, according to Morningstar, which found investor return gaps in dollar-cost averaging scenarios negative across every category group.

“If returns are generally positive, investors are typically better off making a lump-sum investment and holding it for the entire period,” the report said. “Investors who buy and hold can take full advantage of performance trends when total returns are positive, but investors who contribute smaller amounts over time often have fewer dollars invested during periods with strong returns.”

The persistent gap between the returns investors actually experience and reported total returns makes cash-flow timing among the most significant factors — along with investment expenses and tax efficiency — that can influence an investor’s results, Morningstar said.

Morningstar offered these tips for investors to capture more of their investments’ total returns:

  • Hold fewer, more widely diversified funds.
  • Automate tasks like rebalancing.
  • Avoid narrow or highly volatile funds.
  • Use simple solutions like allocation funds.
  • Don’t assume that indexing will translate to superior dollar-weighted returns.

Photo: Adobe Stock


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