Know Thyself: The Hardest Investment Skill to Master

Ask most investors what determines their long-term returns and they’ll most likely talk about their asset allocation, the way they select their fund managers or their track records at getting macro calls right.  

The evidence tells a different story. Across decades of data, the single biggest determinant of investor returns isn’t market or asset class related. It's the behaviour of the person looking back at you in the mirror.  

The Notorious Gap Between What Funds Return and What Investors Receive 

Our regular readers know the story: on average, investors make much lower returns than the funds and ETFs they invest in. 

This notorious return gap comes down to one thing: investors’ poor timing decisions. 

In other words, they tend to buy high driven by greed, and they tend to sell low driven by fear. 

DALBAR tracks this every year in the US, comparing the S&P 500 against what the average equity fund investor actually pocketed.  

2024 was brutal. The index returned 25%, whereas investors captured just 16.5%. That's a shortfall of 8.5%, the second largest in a decade, which was effectively left on the table.  

2025 told a different story. The S&P 500 returned 17.9% against average investors’ 17.2%, narrowing the gap to just 0.7%, the lowest since 2012. Fixed income investors weren't as fortunate though. The Bloomberg Aggregate Bond Index returned 7.3%, while the average fixed income investor captured only 2.4%, a gap of 4.9%. 

S&P 500 Returns (blue) vs Average Individual Investor Returns (orange) 

Morningstar’s ‘Mind the Gap’ study concurs. It tracks actual dollar-weighted returns rather than funds’ own reported returns, and found the same pattern over a longer window.  

Across the decade to 2024, the typical US fund investor gave up 1.2% p.a. versus the funds they held, forfeiting roughly 15% of the gains those funds generated.  

The gap was widest in sector and thematic funds, at 1.5% p.a., and narrowest in diversified, automated allocation funds, at 0.1% p.a. This is an important point for investors: investing in more diversified, less volatile funds inspires much more productive behaviour amongst the investors in these funds. The theory is that lower volatility leads to less greed and fear, both of which tend to sabotage investors’ performance at exactly the wrong moments. 

The Fund-Investor Gap 

Closer to home, analysis by Barclays Private Bank puts the Australian behaviour gap at 1.2% p.a. over the decade to December 2024, which is broadly in line with the US experience. 

So, across continents, the consistent reason investors’ returns consistently trail the investments they hold is behavioural. 

Why Our Brains are Hardwired to Sabotage Our Performance 

Behavioural finance research, building on the work of psychologists Daniel Kahneman and Amos Tversky, has identified a handful of biases that consistently explain the behavioural challenges which affects so many investors: 

• Loss aversion.  

Prospect theory shows losses are felt roughly twice as intensely as equivalent gains.  

This asymmetry pushes investors to sell in a panic during market downturns, locking in the very losses they fear, and to hold too long onto their winners in the hope of avoiding regret in the future. 

• Overconfidence.  

Overconfidence is a major issue for many. 

Research by finance academics Brad Barber and Terrance Odean, drawing on tens of thousands of brokerage accounts, found that the most active traders earned returns 7% p.a. lower than the least active.  

The takeaway is that overconfidence in one’s own market-reading and stock-picking abilities tends to produce more trading, less diversification and lower returns, rather than the better outcomes your ego suggests are coming. 

• Herding and recency bias.  

Humans are herd animals by nature.  

However, when everyone is doing the same thing, following the crowd feels safer than it really is.  

ASX reporting seasons are a good local illustration of this bias. When more than 80 companies report within a single week, some commentators have noted that the compressed timeframe pushes even professional investors towards oversimplified, consensus-driven reactions rather than considered analysis.  

Recency bias compounds this challenge. For example, after a sharp fall, our brains extrapolate the continuation of a bad stretch, even though markets have no memory. 

• Anticipation of loss. 

There’s a physiological angle at play too.  

Neuroscience research using fMRI has shown that the anticipation of financial loss activates the amygdala, the brain region associated with fear.  

Fear-based decisions made under that kind of neural stress rarely resemble the calm, rational process textbook finance assumes. As such, our fears often become self-fulfilling. 

Closing the Gap: What the Evidence Suggests 

Ready to look in the mirror? 

Psychologists distinguish between general knowledge and self-knowledge, and it's only the latter that changes behaviour and habits: 

• Track your decisions, not just your returns.  

Keep a simple trading journal noting what you bought or sold, and, critically, how you felt at the time.  

Over a year or two, you’ll notice patterns emerge, such as selling winners too early out of anxiety, or adding to losing positions to avoid admitting a mistake.  

This is a practical application of what psychologists call metacognition: thinking about your own thinking. 

• Separate the decision from the outcome.  

A good decision can still produce a bad result, and a lucky punt can look brilliant in hindsight.  

Reviewing your reasoning at the time you made a trade, rather than judging it purely on how it turned out, helps break the cycle of overconfidence that a lucky run can create. 

• Pre-commit using ‘implementation intentions’. 

Research by psychologist Peter Gollwitzer shows people who form specific if-then plans, such as deciding in advance to do nothing for 30 days if the market falls 15%, are far more likely to follow through than those relying on willpower alone. 

• Ask what you'd tell a friend.  

Behavioural research suggests we make more rational choices for others than for ourselves. Framing a decision as advice to a friend can strip out some of the emotional noise. 

None of this eliminates fear or overconfidence entirely, since they're wired in. But a written record of your own past behaviour is a far more accurate guide to how you'll act next time than good intentions alone. 

• Reduce discretionary trading around volatility.  

Every study cited above found that the more investors traded in response to short-term moves, the worse their outcomes tended to be.  

Automated, regular contributions remove the emotional decision of when to buy. 

• Favour diversification over concentration.  

Multi-asset and diversified allocation funds consistently show the smallest investor return gaps for the simple reason their smoother ride reduces the temptation to react.  

This is why many successful investors focus on building diversified multi-asset portfolios using broad-based ETFs rather than concentrated single-sector bets. 

• Write down your plan before you need it.  

Decisions made in the middle of a selloff are rarely the same decisions an investor would make with a clear head. That’s when emotions are running high and most likely to drive investors into reactive decision-making that’s at odds with their long-term goals. 

A written investment plan, revisited only at scheduled intervals rather than every time the market moves, is one of the simplest disincentives to emotional trading.  

• Judge funds on more than headline returns.  

Understanding what's really driving a fund’s performance, and whether its volatility profile suits your own temperament, matters more than chasing last year's winner.

Time to Really Look in the Mirror 

Loss aversion, overconfidence and herding are the main behavioural challenges most investors need to overcome, and they intensify during periods of volatility and heavy news flow. 

Diversified, automated and lower-turnover approaches have consistently shown smaller investor gaps than concentrated, high-turnover strategies.  

More generally, self-awareness, rather than superior market timing, is the most reliable edge an individual investor can develop and rely upon. In particular, understanding your own likely behaviour under stress is arguably more valuable than any single investment pick or macro call. It costs nothing to build, and unlike market movements, it’s entirely within your control.  

Disclaimer: This article is prepared by Simon Turner. It is for educational purposes only. While all reasonable care has been taken by the author in the preparation of this information, the author and InvestmentMarkets (Aust) Pty. Ltd. as publisher take no responsibility for any actions taken based on information contained herein or for any errors or omissions within it. Interested parties should seek independent professional advice prior to acting on any information presented. Please note past performance is not a reliable indicator of future performance.