The Behavior Gap
For the twenty-year period ending in December 2013, the S&P 500 Index earned an average annual return of 9.22%. Dalbar, a company that tracks investor returns, reported that the average equity investor earned only 5.02% over the same time period. This phenomenon has been repeatedly observed, by Dalbar and others, and occurs regardless of time period, asset class, and investor experience or education. So how can it be that the average investor earned so much less than the average investment?
Carl Richards has written a book, The Behavior Gap, which savers and investors should read. In his book, Richards attempts to explain why individual investors earn so much less than their investments. Mr. Richards coined the term, The Behavior Gap, to describe the gap between the higher returns that investors could earn and the lower returns that they actually realize. He maintains that many investors’ returns are compromised not because they choose poor investments, but because of their own behavior.
I continually observe that when the stock market goes up, folks want to put more money into stocks and that when it goes down, they want to pull their money out. Study after study confirms that investors all over the world repeat this irrational behavior. Some experts say that humans are wired to avoid pain; thus, we sell because we feel better when we know that we won’t lose any more.
My daughter, Meredith, loves a good sale. She gathers her coupons, finds a bargain, and reports back about the money that she saves. I almost feel sorry for Belk! Would any shopper ever go to the store, buy a product at full price, and return it after it had been marked down, only to receive 60% of the original price? Of course not; a rational shopper doesn’t do this. Yet it is exactly how many investors behave.
What exactly is happening in this so-called behavior gap?
What things are we doing that consistently get in the way of the full potential that our investments have to grow? As it turns out, there is a lot going on in our brains that we don’t know about. For starters, we take mental shortcuts. Our brains default to association and intuition rather than processing data. And although we often know what the rational decision would be, we give in to emotions like fear or greed. We are impatient, and we tend to value the ability to enjoy something now more than the idea of enjoying a lot more in the future. Speaking of the future, we typically believe that we can predict it, although when look at our mistakes in the rearview mirror, we frequently don’t learn from them and go on to repeat them. That’s quite a roster of obstacles to overcome, and I will explore these in future columns.
What can you do as an investor to narrow The Behavior Gap?
First, recognize that this is how your brain works and that your mind has a tendency to work against your money. Force yourself to slow down and use the deliberate, information processing part of your brain when you are making financial decisions. Next, formulate a long-term financial plan that marries your portfolio to your personal goals, not to some market index. Then sit back and resist the urge to overhaul your investment strategy the next time the market stumbles.
Accept that investing is more about your behavior than it is about skill or the particular mutual fund that you own. You will outperform almost all other investors if you can simply control your emotional reactions and behave correctly!
All of this is easier said than done. Give us a call if you need assistance.
Meet the Author
Tom Coulter, CPA
Tom is the President and a founder of Meridian Trust. Tom graduated from The University of Tennessee, Knoxville, in accounting with honors, in 1978. Tom previously worked for the international accounting firm, Deloitte. He later joined the financial medical advising firm, FIS Associates, before founding Meridian Trust in 1997. Tom has worked extensively in retirement planning, taxation, estate and financial planning and investment management. He is a Certified Public Accountant, a member of the American Institute of CPAs (AICPA), and the Tennessee Society of CPAs (TSCPA).
Tom is also credentialed as a Personal Financial Specialist (PFS) by the AICPA.