Learn how the behavior gap works and how to close it.
What is the behavior gap?
In his book “The Behavior Gap: Simple Ways to Stop Being Silly With Money,” financial planner Carl Richards uses the term “behavior gap” to describe the difference between the higher returns that investments tend to produce organically and the lower returns that investors earn due to their behavior.
Richards’ behavior gap theory suggests that many investors earn lower returns not because of the investments they choose, but because of how they use them. If these investors behaved differently while continuing to use these same investments, they may do better.
How the behavior gap works
Richards posits that there is a difference between returns to investors and returns to investments. Specifically, he claims that the actual returns investors earn are lower than the returns on the average investment.
According to MorningStar, the rates of return for investors were slightly lower (by five basis points per year) than the total investment return for the 10 years ending December 31, 2019. However, the gap in behavior has been reduced.
This behavioral gap stems from irrational investment decisions driven by the desire to avoid pain and seek pleasure in the form of above-average returns, known in the investment industry as “alpha.” Such decisions include selling when investment prices are low or switching from one investment to another based on the selection of a stock analyst on television.
But instead of rewarding investors with alpha, these irrational decisions can lead investors to lose capital or buy investments when they are “high” or more expensive, which can ultimately lead to lower rates of return.
For example, let’s say you have 1,000 shares invested in AlphaTech, worth $1,000. The stock market crashes and the share price halves overnight at $0.50. He now has 1,000 shares worth just $500. Although he hasn’t realized any losses yet, he opts to sell all of his AlphaTech shares the next morning, operating on the assumption that the price will continue to fall. But instead of falling, the share price rises to $0.75 by the end of the next day, reaching $1.50 when the market recovers. As he sold his investment, he realized a $500 loss and a -0.5% rate of return, whereas he would have received a 0.5% return if he had patiently held on to the investment. The gap between the return on the investor and the return on investment is 1%.
Richards offers a host of sketches that provide poignant illustrations of investment behavior on his website, BehaviorGap.com.
How to close the behavior gap
The difference between average and realized investment returns can be minimized by taking a disciplined approach to invest and relying on a logical process for making decisions. Using a consistent analytical approach should help you avoid making reactionary and overtly emotional investment decisions in tough times.
There are several steps you can take to achieve that goal:
- Do your research – Spend some time reading reputable financial magazines, newsletters, and books. That investigation should include an examination of trends both in the recent past and in earlier times when your finances were materially affected. In her book, Richards offers a lawn mowing anecdote to explain the value of research in making investment decisions. If you mow without first finding out where the sprinkler heads are, you will run over the sprinkler heads. Likewise, if you invest without doing your research, you won’t like the rate of return.
- Take a Diversified Approach – If you put all your eggs in one basket and lose, you could lose a lot. Diversify the asset classes (stocks and bonds, for example) and the individual industries and securities in which you invest. Richards says that being dissatisfied with at least one investment in your portfolio is a sign that you’re diversified.
- Stick to your investment strategy – Richards points out that the rates of return touted in investment marketing materials are based on a buy-and-hold strategy of buying an investment once and holding it for the long term, but such a strategy isn’t always implemented. by investors, resulting in below-average returns. Instead of chasing fads, switch to analyst-recommended “hot” stock picks, or sell low because you thought you could time the market, be patient, and stick with your investments for the long haul. Rebalance your portfolio as needed to maintain your desired asset allocation.
- Consult a Financial Planner – Using the services of a financial advisor or financial planner can provide a buffer between your emotions and the financial decisions you commit to. It can also help you avoid mistakes that lead to the behavior gap.
- Have the “Overconfidence Talk” – Richards coined this term to describe a conversation investors should have with friends or family before making big money moves when they are overconfident in their knowledge. Ask questions about whether you are right to make the change and how the change will affect your life, what will happen if you act and make a mistake, and if you have been wrong before.
- The performance gap is a term coined by financial planner Carl Richards that refers to the difference between investors’ actual returns and average investment returns.
- The gap arises from irrational decisions motivated by the desire to avoid pain and seek pleasure and can lead to losing capital or buying investments when they are more expensive, which can reduce returns.
- Doing your research, diversifying your portfolio, maintaining your investment focus, consulting a financial planner, and passing your choices on to friends and family are all methods investors can use to bridge the behavior gap.