How The Behavior Gap Affects Investor Returns
The key to successful investing is not the investment performance but the investor performance. Many of us believe that our goal as investors is to search for the investment that is better than average. But it turns out that searching for this so-called best investment leads to behavior that ends up costing us money.
The Behavior Gap
It means that as investors we end up doing worse than the average investment – mostly due to our poor behavior. This behavior gap is the difference between the average investment return and the average investor return, or the distance between what we should do and what we actually do.
Related: How to calculate your portfolio rate of return
As Carl Richards explains in his book, The Behavior Gap:
“It’s not that we’re dumb. We’re wired to avoid pain and pursue pleasure and security. It feels right to sell when everyone around us is scared and buy when everyone feels great. It may feel right – but it’s not rational.”
Richards says he grew tired of watching people he cared about make the same mistakes over and over with their money all because they let emotion get in the way of making smart financial decisions.
Editors note: You should buy this book for the authors’ simple drawings and sketches alone – they are priceless.
Dalbar Study
According to the most recent study by Dalbar Inc., which analyzes investor behavior, average equity fund investors earned 4.25 percent annually between 1993 and 2012 compared to the S&P 500 index, which returned 8.21 percent over the same period – a difference of nearly 4 percentage points per year.
Related: Do stock market cycles influence your investment behaviour?
The study found that more than half of the gap in investment returns can be linked to performance chasing and other bad investing habits. The message from Dalbar has been consistent since its first study in 1994:
“No matter what the state of the mutual fund industry, boom or bust: Investment results are more dependent on investor behavior than on fund performance. Mutual fund investors who hold on to their investment are more successful than those who time the market.”
Understanding this behavior gap – and your own behavioral tendencies – is crucial to achieving better investment returns. Accept the fact that no one can accurately predict what the stock market is going to do and that very few investors can consistently pick better than average investments.
Related: Why certain world events spark totally irrational behaviour
Richards says that even though we all make mistakes we need to review them and identify our personal behavior gaps in order to avoid them in the future.
“The goal isn’t to make the ‘perfect’ decision about money every time, but to do the best we can and move forward. Most of the time, that’s enough.”
Final thoughts
If you are constantly trying to guess where the stock market is going and chasing last year’s winners then there’s a good chance that your investor behavior gap is going to eat away at half your potential savings or more.
Related: Avoid these four investing mistakes
Instead, focus on what you can control – building an investment plan that you’re comfortable with so that if the markets go for a wild ride, or there’s an economic crisis is China, or Jim Cramer is yelling about something, you can tune out the noise and just stick with your plan.
I find investing in dividend stocks helps take some of the emotion out of investing. I know the dividends will keep coming in regardless of what is effecting the market so it almost becomes routine or even boring. I’ve given up trying to time the market as it usually doesn’t work (for me) and I try not to chase past performance – although it is sometimes tempting
I was a big fan of Carl Richards’ drawings but he is a poor source of financial advice or expertise. You say he said “he grew tired of watching people he cared about make the same mistakes over and over with their money.” Well he made the most mistakes of them all.
The advice in you post is spot on but Carl Richards is not one to talk.
I definitely believe his analysis. I used to be one of these types of folks until I saw the light that you cannot realistically beat the market over the long term unless you’re cheating – which has the pesky problem of being illegal!
I’m with Dan above, I find investing in dividend stocks helps take my emotions out of the equation.
I’m becoming more of an indexer, holding more XIU and VTI over time but I won’t sell my individual stocks unless something dramatic happens. I even hold a bit of TA.T, just a small portion which is good.
Mark
I’ve been watching some of the new mo-mo stocks lately – Tesla, FB, Zulily, etc, and people still don’t change. It’s the same old cult-like belief in non-sense that is going to make a lot of people a lot poorer.