Individual investors get lower returns than they should. According to a recent study by Jason Hsu of Research Affiliates and coauthors, even though the compound return on the S&P 500 was 8.97% per year from 1991-2013, the average stock mutual fund investor earned only 6.87%, a full 210 basis points per year lower. Other studies have found similar results, and the same pattern has been shown for investors in bond mutual funds. The return shortfall earned by the average investor is due to predictable mistakes that can be avoided.

In a prior column, I noted that individuals do worse than buy-and-hold investors because
• Most mutual fund fees are too high.
• Most investors chase past returns, and thus buy growth funds after growth stocks have done well, and before they do poorly.
• Investors do a bad job of market timing. They pour money into stock funds after stock returns have been high, and take money out after stocks have done poorly.

The second and third points are related. Within an asset class, investors tend to chase past winners. Across asset classes, investors tend to chase past winners. Both contribute to underperformance.

On an after-tax basis, the average investor does even worse. Buying a mutual fund that has had high past returns exposes a new investor to capital gains taxes on the stocks that went up before the investor bought in.

It is easy to avoid some of the causes of low returns. ETFs and low-fee mutual funds give investors higher after-fee returns, because on average high-fee managers do not earn enough extra return to compensate for the higher fees. Funds with loads or 12b-1 fees are particularly to be avoided.

Investors who buy individual stocks or ETFs do not avoid all of the mistakes that mutual fund investors make. Most investors in individual stocks and ETFs also chase past returns, trade too much, and may be losing the benefits provided by diversification. In general, the more an individual trades, whether using individual stocks, mutual funds, or ETFs, the worse the person does (unless the trading is actually designed to achieve diversification), because they are more likely to be chasing past returns. A site that devotes itself to encouraging investors to avoid these pitfalls and others is Folio Investing, where an investor can also have a personally customized portfolio.

Buying and holding index funds, which generally have low fees, is another means to avoid the underperformance caused by high fees and frequent trading. The more a person is a buy-and-hold investor, the less likely the person is to chase past returns.

Individual investors can buy low-fee ETFs and mutual funds through such firms as Vanguard and Wisdom Tree. ETFs on indices with a value tilt, known as fundamental indexing, that are managed by Research Affiliates can be purchased through Schwab. As noted above, low-fee portfolios tailored to the individual can be purchased through Folio Investing. For individuals with a fee-only financial advisor, Dimensional Fund Advisors and Vericimetry offer low-fee mutual funds with low portfolio turnover. Their funds have historically outperformed other funds. I have money invested in mutual funds managed by Vanguard and Vericimetry, and I own ETFs managed by Vanguard and Wisdom Tree.