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Sources of Systematic Underperformance

The Performance Gap

Study after study (Dalbar, SPIVA, Morningstar) shows that the average investor earns significantly less than the market index and the funds they invest in. This gap is systematic, not random.

The Behavioral Gap

Formula: Investor Return = Investment Return - Behavioral Cost

Where:

  • Investment Return: What the fund/market actually did (e.g., 10%).
  • Investor Return: What the investor actually pocketed (e.g., 6%).
  • Behavioral Cost: The 4% lost to bad timing (buying high, selling low).

Key Behavioral Causes

1. Overtrading (High Turnover)

Mechanism: Buying and selling frequently in an attempt to time the market or pick winners.

  • Cost: Transaction costs (brokerage, STT) + Tax drag + Bid-ask spreads.
  • Evidence: Barber & Odean found high-turnover accounts lag low-turnover accounts by ~6.5% annually.

2. Performance Chasing (Recency Bias)

Mechanism: Pouring money into funds after they have had a great run (buying high) and selling funds after a poor run (selling low).

  • Result: Investors consistently hold assets during their underperformance phase and miss their outperformance phase.
  • Mean Reversion: Today's winners are often tomorrow's losers.

3. Disposition Effect

Mechanism: Selling winning stocks too early (to lock in gain) and holding losing stocks too long (hoping for break-even).

  • Impact: Portfolio is filled with losers ("weeds") while winners ("flowers") are cut.

4. Poor Diversification (Home Bias & Concentration)

Mechanism: Holding only Indian stocks or only tech stocks.

  • Risk: Uncompensated idiosyncratic risk. If that sector/country underperforms, the entire portfolio drags.

Structural Causes

Fees and Expenses

  • Impact: High expense ratios (2%+) compound over time to erode wealth.
  • Behavioral Link: Investors often ignore fees (small numbers) but chase past returns (large numbers), failing to realize fees are the best predictor of future net returns.

Taxes

  • Impact: Short-term capital gains tax (15-20%) eats into returns far more than long-term tax holding.
  • Behavioral Link: Impatience prevents tax-efficient compounding.

Preventing Underperformance

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Key Takeaways

  • Gap is Real: Investors lag markets by 3-5% annually due to behavior.
  • Main Cuprits: Overtrading, timing attempts, and performance chasing.
  • Math: Costs and taxes are certain negatives; alpha is uncertain positive.
  • Solution: Systematic investing (SIP), low turnover, and index funds.

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