What is the behaviour gap?

The behaviour gap is the difference between the return an investment delivers and the return its investors actually earn. It arises because investors tend to buy after prices have risen and sell after they have fallen. A fund may return 8% a year while the average euro invested in it earns considerably less, because more money was in the fund during its bad years than during its good ones.

How it is measured

The investment's own performance is its time-weighted return, which ignores when money came and went. What its investors actually earned is the money-weighted return of all the money that flowed in and out. The difference between the two is the behaviour gap:

\text{Behaviour gap} = \text{TWR} - \text{IRR}

Research such as Morningstar's recurring "Mind the Gap" studies estimates it for funds by comparing their reported returns with the money-weighted returns of their investors' cash flows. It has typically found gaps of around one percentage point a year or more on average, and larger ones for volatile and specialized funds.

A simple illustration

A fund returns +30% in its first year and −20% in its second. An investor puts in €10,000 at the start; impressed by the first year, they add €17,000, bringing the investment to €30,000, just before the second year. It ends at €24,000.

The fund's time-weighted return over the two years is:

\text{TWR} = 1.30 \times 0.80 - 1 = 4\%

The investor's money-weighted return is the rate $r$ that balances the cash flows:

-10{,}000 - \frac{17{,}000}{1 + r} + \frac{24{,}000}{(1 + r)^2} = 0 \quad \Rightarrow \quad r \approx -8.3\%

The fund gained 4% over two years; its investor lost €3,000 of the €27,000 put in, about −8.3% a year. The difference is entirely due to timing.

Why it happens

Performance chasing: buying what has recently done well, often near a peak.
Panic selling: selling after sharp falls, locking in losses before a recovery.
Frequent switching between funds and strategies, each time after the previous one disappointed.

How to avoid it

Automate: regular savings plans and scheduled rebalancing keep decisions away from the emotions of the moment.
Choose a portfolio that can be held through a crash, not only one that looks good in calm markets.
Compare the two returns. A money-weighted return persistently below the time-weighted return is a sign that timing decisions are costing money.

See these numbers for your own portfolio

Floreo works out every figure on this page from your own holdings — returns, risk, allocation, currencies — and the assistant explains them the way this page does. Import from your broker, or try it on the sample portfolio first.

Start Demo

The demo opens straight away on a sample portfolio — no account needed.