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.
As if you didn’t already worry more than enough about retirement, now is probably a good time to worry about having too much money.
No. Really.
The problem won’t be that you’ll have saved too much, so you can stop that thought in its tracks right now. No, the real problem is that by leaving your retirement income withdrawal strategy in the hands of the government, you, like many normal, everyday (read: not rolling in money) Canadians are likely to find yourself required to take more money out of your RRIF at age 72 than you’d planned, exposing more of your savings to tax earlier than you’d like, and potentially jeopardizing the sustainability of your retirement income forever.
Related: Necessity Tetris – Retirement Income Edition
You see, like the Terminator, and unlike withdrawals from RRSP accounts, RRIF withdrawals never, ever stop. (Not until you do, at any rate.) You can’t turn withdrawals on one year and turn them off the next, and there’s a minimum amount that you must withdraw, depending on your age. If you wait until age 71 to convert your account, the minimum withdrawal amount the following year is 7.48% of your RRIF balance.
Still don’t see the problem? Let’s use a real scenario:
You and your spouse have worked reasonably hard all of your lives until age 65, and have saved $400,000 in RRSPs for your retirement. Neither of you has a pension, you’ll both receive slightly more than the average CPP entitlement, and you’ll both be fully eligible for OAS.
You’ve always lived a pretty modest lifestyle, your house is paid for, and you have neither debt, nor plans to travel the world, nor children you care to leave a big inheritance to.
You figure you’ll be able to live comfortably on $45,000 per year (of which only about $15,000 will have to come from investments), which should leave you some wriggle room in case you need to pay for long term care somewhere down the road. You’ve done the math, factored in inflation, and are feeling cautiously optimistic that you’ve planned well for your retirement.
Related: What’s All This Retirement Planning For, Anyway?
And then you run into the RRIF problem. If you leave your withdrawal strategy in the hands of the government and delay it until the last possible year, you’ll find yourself at age 72 with a minimum withdrawal somewhere in the neighbourhood of $30,000 for both spouses, almost double what you need (or want, if you’re hoping that your investments will last just as long as you will.) If you convert your savings to a RRIF and start withdrawing at 66, your minimum withdrawal hovers in the $16-$18,000 neighbourhood until age 71, when it jumps to $27,000.
I have to assume that someone, somewhere in the bowels of the government has their eye on mortality rates, savings rates, and safe(r) withdrawal rates, and that a crack team of experts is working on the problem. While we wait, there are a few things you can do, depending on how close you are to retirement:
If you’re years from retiring:
Keep your eye firmly on your current tax rates and your expected income in retirement. There’s very little point in transferring part of your tax burden into the future through RRSPs if your income then will be the same or more than it is now, but even if you expect lower income once you retire the spectre of minimum RRIF withdrawals shouldn’t deter you from sheltering your long-term investment income from tax.
If you’re within ten or fifteen years from retirement:
Now’s the time calculate how your government entitlements, pension benefits, and own savings will fit together as precisely as you can to use the RRSP and TFSA rules to your maximum benefit.
Related: Cynicism, The Canadian Pension Plan, And You
If you’re only a few years away from retirement:
Planning is your friend, but with the proximity of retirement comes the benefit of more precise planning, and your calculations are going to be more accurate than at any other time.
You might start strategically withdrawing from your RRSPs in-kind before converting to a RRIF, to reduce your minimum withdrawals. You might start eyeing your growing TFSA contribution room as a better place to invest for long-term growth than your RRSP.
You might convert only part of your RRSP to a RRIF, and use the other part to buy an annuity with a constant regular payout instead of a minimum withdrawal. You might even take your minimum RRIF withdrawal in-kind, and leave the investment in a non-registered account to keep growing.
The one thing you won’t (or shouldn’t) do is shake your fist at the government, yell into the wind that you’re being penalized for saving, and then opt out of the retirement savings system altogether. It just isn’t one of the options.
Sandi Martin is an ex-banker who left the dark side to start Spring Personal Finance, a one woman fee only financial planning practice based in Gravenhurst, Ontario. She and her husband have three kids under five, none of whom are learning the words to “Fidelity Fiduciary Bank” quickly enough. She takes her clients seriously, but not much else.
In the 18th century, French philosopher Denis Diderot received a gift of a beautiful scarlet dressing gown. I know it’s not something your typical guy today would get too excited about, but remember this was the 1700’s. In any case, he was delighted with his gift and promptly discarded his old dressing gown.
Within a short time he grew dissatisfied with his surroundings. They didn’t reflect the elegance of his new robe. In fact they were downright shabby.
Related: What’s busting your budget?
One by one he started to replace the worn furnishings in his study – the old desk and chairs, the threadbare and faded drapes, and even his old bookshelves – with classy, expensive, new items that properly reflected the look of his new robe.
Soon he plunged into debt.
Diderot wrote an essay called “Regrets on Parting with my Old Dressing Gown,” claiming his beautiful new gown had become a curse, not the blessing he first thought.
The Diderot effect
Have you ever noticed how upgrading one thing leads to upgrading something else?
Today, the need to up-sell yourself is known a the “Diderot Effect.”
You know how it goes:
- You purchase a new house and you need new furniture to fill it.
- A new skirt needs a new blouse to match.
- An upgrade in china can’t be enjoyed without a corresponding upgrade in table linens, flatware and glasses for every drinking occasion.
- A new washing machine needs the matching dryer.
- That shiny new fridge looks out of place in your dreary kitchen.
As new items are bought the remaining items appear less attractive in comparison. Each item on a wish list leads to another item, always ascending like an escalator.
Related: Why today’s appliances look good, but don’t last
It may cause you to spend more money than you anticipated for an entire chain of new purchases. It’s easy to fall into the trap.
A work in progress
I fell under the influence of the Diderot Effect when I decided to repaint my living room. To offset the new colour I painted all the trim a nice fresh white. To paint the window trim required taking down the poufy window valance – a relic from the 1990’s, long past its prime – so I needed new window coverings.
The old doors looked ugly and dated with the new trim, so off to the home renovation store we went to purchase six new white doors – with all the hardware. I decided to buy levers instead of round knobs thinking it would be easier to open doors when my hands were full. (I didn’t consider that every small child that visits now has easy access to each room in my house.)
Related: Do home renovations pay off?
Next, the poor excuse for lighting became an issue and now the carpet is rearing its ugly pile.
Final thoughts
Diderot lived to regret his home improvement project. He hadn’t previously noticed how tattered the old gown was because it was comfortable and blended into his surroundings.
But we have no regrets. We did the work ourselves and opted for the pay as you go method. It’s still a work in progress and I’m sure we’ll have to begin all over again when we’re done.
Diderot’s complaint was that his comfortable little study lost its original homey – if shabby – character. Well, at least everything matched.