Why Your Investments Are Doing Well but Your Investment Account Isn’t

I recently met with a small business owner who was frustrated with his 401(k) plan. It was expensive, underperforming, and he was evaluating options to improve it somehow. As I spoke with him about what he valued in a plan, he was very focused on investment performance returns. He wanted to know how well the funds had performed in the past, and what kinds of returns he could expect. All great questions—the kinds of topics plan sponsors should be considering. But I noted that he didn’t seem to place much value in service to help his employees make better investment decisions.

Why didn’t he care? It’s simple: like many employers, he didn’t understand the critical difference between investment returns and investor returns. This is a big deal, because while it might seem to make sense to choose a 401(k) plan based on the historical performance of its investment options, I have seen that there is a significant gap between the performance of a given fund line-up and the returns actually received by employees who invest in that fund line-up. Compounded over many years, this can result in a sizable asset gap at retirement.

Let’s take a look at how investors might perform differently from the investments they choose, why that performance gap happens, and what can be done to make sure employees are getting as much as possible out of their investments.

Investment Returns vs. Investor Returns

“Investment returns” refers to how a fund performs over time, in specific reference to how much it grows or does not. Most people would evaluate a fund’s performance by looking at how much the value of the fund goes up over a 1, 3, 5, or 10-year period, after fees have been removed. Those numbers are best compared to an industry benchmark, or against similar peer group of funds over the same period of time. The comparison allows us to see the incremental performance of the fund they chose over the index and others like it out there. If a fund does better on average than similar funds or benchmarks, then we’d say it performed well. All standard stuff, but here is the tricky part.

You might think that the performance of the funds in your 401(k) plan would match closely with the actual returns of your employees who are invested in those funds. Over long periods of time, that is seldom the case. When we look at “investor returns,” we look at an employee’s money invested into a series of funds over a 1, 3, 5, or 10-year period to see how much that money actually grew. Many employers will be surprised to learn that if you compare those investor returns to the baseline investment returns, the numbers are typically quite different over longer time periods.

In fact, according to the research that I have reviewed, employees should expect to see returns that are 1-3% lower than the overall performance of their chosen fund lineups. I will address why that occurs in a moment, but first, why is a few percent a big deal? Consider this: an average American worker starts with $30k in their 401(k) plan. Over 30 years, a plan that grows at a rate of 8% will be worth $301,879.71, while a plan that grows at 6% will only be worth $172,304.74. The performance drag that 2% difference creates is enough to almost cut in half what that worker will have saved come retirement.

What Causes the Performance Gap?

The reason for this performance gap is investor behavior. The research that I trust most shows that investors tend to make small changes slowly over years or decades. In your average 401(k) plan, 1 out of 10 people in a given year will make a material investment change, which means that over a 3 or 5-year period, 30-50% of employees will have done this, and over a working career, almost everybody has. But those changes often work to their detriment. One reason for this is the flawed logic in evaluating funds based on past performance. In my experience, people tend to put more of their money into what has done well in the past. They’ll take a 3 or 5-year performance history, determine which available fund has done the best, and put more money into that.

But past history doesn’t necessarily indicate future performance—in fact it usually doesn’t. Of 641 top quartile performing funds in 2014, only 7.3% were still top performing just two years later.* Investors who had selected a top performing fund in 2014, might feel disappointed today. When they see investments aren’t performing as well as they’d like, they decide it is time to make an investment change. And I see people changing their investments based on what they see about the market on TV. People watch CNN, and they hear that the Brexit might make a big impact on the market, or that interest rates have changed, so they get involved and take their money out of whatever funds they’re in and put their money into other “top performing” funds.

And that investor behavior can be most extreme around extreme market movements. Remember the market drop back in 2008/2009? I remember a heated and protracted dialog I had with a client at that time. He owned automotive dealerships, and didn’t need short-term cash from his investments, but around March of 2009, right near the market bottom, he was just tired of watching the market go down, and he felt desperate to “do something about it.” In hindsight, the very best thing to do at that point of time for his situation was simply to do nothing. He needed to stay invested, but that was almost impossible for him to do without professional help. In the investment trade we call this “buying high and selling low”.

Regardless of why people choose to change up their investments, the research shows that too many people are buying high and selling low. In fact, a recent study from Dalbar showed a hypothetical $1M investment over a 20-year period. If the investor had bought into a fund lineup that was blended well and the investor did not make any changes in 20 years, they’d have gone from $1M to $6.5M. An investor who started with $1M but who made changes as individual funds went up and down would only have gone from $1M to $2.5M. You can see how expensive it is to buy stocks when they’re high, then sell when they’re low.

I think this is pretty clear: if an investor holds a good mix of investments, they’ll do better over time than a reactionary and always-changing investment strategy will.

Bridging the Gap

What, if anything, can be done about this? For me and my team, the solution is all about providing employees with the help they need to better understand what it will take to reach their own retirement goals and focus their investment strategy accordingly. I believe many of the poor investment decisions employees make stem from a lack of support. In a recent study we commissioned, we found that only about 50% of Americans are offered financial education or one-on-one counseling services from their 401(k) service provider. And we don’t know about the quality of the one-on-one counseling that is received.

This is crucial because, when left alone, an employee’s investment approach might be to invest in funds with a good history, then dump those funds when they underperform and jump to another investment. We would much rather see employees follow a goals-based approach to investing, instead of buying and selling their investments based on the market at any random point in time.

Ultimately, I believe good 401(k) investment strategy comes down to this very simple truth: if your retirement goals or needs haven’t changed, then most of the time, your investments probably shouldn’t change much either.

*S&P Dow Jones Indices. “Does Past Performance Matter? The Persistence Scorecard. August 2016.

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