4 reasons your investor returns may not match the market

Whether you're hanging out with friends or gathered around the water cooler in the office, the news of the day is often the topic of conversation. That includes the stock market — especially if it's on a tear. If you haven't been keeping a close eye on your accounts, the news may surprise you, and you might rush to check your investment portfolio. But don't be surprised if you discover your financial outcome doesn't exactly line up with market performance.

It's not unusual for investor return to not perfectly match market performance, even when the market is on a hot streak. Here are four reasons why.

Reason #1: Expenses and fees

There is a price to doing business, and it comes as expenses or fees. There are many different types — mutual fund annual operating expenses, annual account maintenance fees, brokerage fees, and more. That can take a bite out of an investor's bottom line when buying or selling a stock or bond, regardless of market performance.

For example, if a mutual fund earns a 6% return and has 0.5% in expenses, the investor earns 5.5% — a little bit less than the full 6% the fund earned.

Or let's say you purchase 10 shares of a $10 stock for a total of $100. If your online broker charges $3 for this transaction, your price per share is not $10, it's $10.30. That means the total cost of your 10 shares is $103, not $100.

If you're charged another $3 when you sell the stock, that's a total of $6 in fees, which reduces returns. The stock would need to increase in value from $100 to $106 for you to break even after accounting for the costs of buying and selling.

While fees and expenses can be minimized, it's hard to avoid them altogether. These fees pay for the management of the investment. In the case of a mutual fund, the fees pay for expenses like the salary of the portfolio managers, the cost of sending out quarterly statements, and for compliance personnel who make sure everything is operating according to appropriate federal regulations. These expenses also cover the mutual fund's transaction costs for buying and selling securities.

The key takeaway here is to pay attention to fees as they reduce return. That's why low fees are one of the biggest advantages of the Thrift Saving Plan (Opens in New Window).‍ ‍ ^{See note 1}

But a word of caution: Lower fees don't always mean a better investment. If Mutual Fund A has an expense ratio of 0.02% and Mutual Fund B charges 0.5%, Mutual Fund A isn't automatically the better buy. If Mutual Fund B is consistently outperforming Mutual Fund A by 2 to 3 percentage points each year, the expenses might be worth it to earn a better return.

Of course, if the funds are performing the same and there are no other investment factors to consider, then minimizing expenses helps the investor maximize return.

Reason #2: Taxes

Another investment factor that can reduce investor return is taxes. How much the investor pays depends on several things such as the tax efficiency of the security, the types of distributions the security has, and the investor's personal tax bracket. A tax advisor or financial planner can help you with specific questions.

Most of the time, taxes become a factor when a security like a stock is sold. For example, if an investor purchases Security A and holds it for 30 years and the stock price increases from $1 to $100,000, the investor won't pay taxes as long as he or she doesn't receive any dividends from the security — any gains are only on paper at this point. Technically, the investor has not made any money yet, and won't until the security is sold.

A mutual fund is a little different. Let's say a mutual fund increases in value by $2,000 and distributes $1,000 in long-term capital gains to the investor. That $1,000 is taxed at your long-term capital gains tax rate, which we'll say is 15% for this example.

That means you will owe $150 in taxes on the $1,000, so your net profit is effectively now $1,850 not $2,000. While the investor may not have sold the mutual fund, the portfolio manager did sell some securities that make up the mutual fund and it produced a taxable gain.

Reason #3: Purchase price

Purchase price also affects investor return. Your return is based on the difference between the purchase and the selling price, minus any fees.

Consider this example: Bill and Bob both sell security XYZ for $35. Bill paid $30 for XYZ and Bob paid $28. That means Bill earned a 16.6% return and Bob earned a 25% return, all because of the difference in purchase price.

The same goes for an ETF, a mutual fund that trades like a stock. ETFs may sell at a premium or a discount; when trading above its Net Asset Value (NAV), it's considered to be at a "premium." That means the investor will pay more for that ETF. The opposite is true when it's trading at a discount.

Reason #4: Trying to time the market

Time in the market offers a better path to success than timing the market, or when an investor tries to guess the exact bottom of a drop to buy at the lowest possible price — or when the investor tries to guess the exact top of the market to get the highest possible selling price.

The cost of missing just a few days in the market

We all know markets go up and go down. But no one knows for sure when the ups and downs will occur or when they will top or bottom out, which means missing even a few days in the market could significantly impact the performance of your portfolio.

An example of the effects of bad timing: From January 3, 2000, to December 31, 2019, the S&P 500 returned 6.06% on an annual basis. That's approximately 5,000 trading days. If you missed just the best 10 days out of those 5,000, the return dropped to 2.44%. If you missed the best 30 days out of the 5,000, you experienced a -1.95% return.

I can't guess the best 10 days out of the last 5,000 trading days which is why we all need to think of ourselves as investors, not day traders. An investor focuses on the long-term more than the short-term. Avoid the temptation of trying to time the market. Base your investment decisions on your goals, time frame, risk tolerance, and risk capacity, and build a diversified portfolio.

Ready to get started?

Investing requires discipline. It takes time to understand risk tolerance and risk capacity, and how they affect long-term and short-term market fluctuations. If you're just getting started, check out this guide for beginners.