“Psychology seems to lie behind all the ways that potentially improve stock market returns.” – Ben Stein and Phil Demuth (The Little Book of Alternative Investments)
One of the most fascinating aspects of finance lie at the intersection of psychology and money. This is referred to as behavioral finance. One of the well-researched areas of behavioral finance is “The Behavior Gap” - A term coined by Carl Richards to describe why an investor trails behind their benchmark return, even when they hold the exact same investment as the benchmark. A lower return with the same investments. How could this happen? As the name implies, the difference between the returns has to do with your behavior and emotions.
Suppose the following example (Not actual investment numbers): You put $1,000 in an investment in January 2018. Your investment does not return much throughout the first part of the year, and in October you have $1,020.
Then, in the dreaded 4th quarter of 2018 your investment starts to fall in value, quickly. At Christmas, your investment is now only worth $830. Scared that we you will lose more or all of your investment due to an impending recession, you sell. You’ve now locked in a -17% return and have $830.
However, from Christmas Day 2018 until March 2019, the investment that you used to own grew 16%. At that point, you decide the investment seems to continue to increase in value, so you put your money back in the investment, and it grows another 4% throughout 2019.
Your $830 grows to $863 (4%) at the end of 2019. This means that your total investment return in 2018 and 2019 is about -14%.
If your eyes glaze over with the math from above, you can pick back up here: If you did not get scared and sell your investment for those 2 months, your investment would be at $1,001 (vs $863). This means you did not have much investment growth throughout 2018 and 2019, BUT you would have faired 14 percentage points better if you did not sell. This is the behavior gap. The same investments, but your emotions and subsequent behavior resulted in 14% loss.
Easy enough, right? Now that you know that everyone has this natural tendency, you will just avoid falling for the behavior gap trap. It’s not as simple as you may think. Simply understanding this natural bias doesn’t protect you. Psychologist Dr. Daniel Crosby who has researched and written extensively on the topic of the intersection of psychology and finances puts it this way:
There are all sorts of educational resources available to the retail investor today – blogs, white papers, all the way to robo-advisors that will automatically create a near perfect asset mix – but none of these things can prevent the panicked investor from being their own worst enemy. I liken it to nutritional information which is widely available and widely ignored. In fact, some research suggests that restaurants that list calorie counts on the menu actually lead diners to eat slightly *more* than those that don’t list them. Investors do not need an advisor to tell them how to invest; a long weekend of reading the right books would point the average investor in a good direction that could be implemented simply and cheaply. However, that very same investor is highly unlikely to stick with that plan through thick and thin, which is the only thing that matters in the long-term.
So what can you do?
Look for a financial advisor who can help you manage not only your finances but also your behavioral tendencies toward your wealth. In a research study, Vanguard found that on average a financial advisor adds 3% of additional return to client’s portfolios, but surprisingly, half of this excess return (1.5%) was due to behavioral coaching. Furthermore, this statistic is only concerning the investment management side of financial planning. Working with a comprehensive planner helps you, both behaviorally and strategically, to grow and use wealth wisely in many other areas.
Here are some characteristics that a good financial planner will have if they are adding value to your financial plan with behavioral coaching.
Still determined to go at it alone?
You’re not alone in that mindset. A study by Morningstar mentions that despite a 1.5% in additional investment return added by an advisor providing behavioral coaching, it is listed as the least-valued attribute in a financial planner. If you decide to go at it alone, here are a few tips to stick by.
Now that you understand the behavior gap, you have the first step down. Now, the next step is to protect yourself… from yourself. If you’d like to see our investment management strategies, get a free portfolio review, or talk a little bit more about this behavior gap, click here.
Bennyhoff, D.G. and Kinniry Jr. F.M., ‘ Advisor’s Alpha’, Vanguard.com (April, 2013)
Crosby, Daniel. The Laws of Wealth: Psychology and the Secret to Investing Success. Harriman House, 2016.
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