It might surprise you to learn that when it coms to managing their personal finances, many people act in an irrational way that damages their economic and financial self-interest. In fact, there’s a term that describes the negative impact of poor decisions made by investors: the behavior gap.
This is the title of a book published a few years ago that purports to reveal “simple ways to stop doing dumb things with your money.” The author states: “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.”
The new but growing field of behavioral finance suggests that there are predictable ways in which individuals — and investors, in particular — act irrationally. This is because financial and investment decision-making is heavily influenced by human psychology.
This fact was born out by the most recent Dalbar Quantitative Analysis of Investor Behavior, an annual study that measures the effects of investors’ decisions to buy, sell and switch into and out of mutual funds. According to this analysis, investors are often their own worst enemy when it comes to increasing returns in their investment portfolios.
The behavior gap for equity mutual fund investors in 2014 was 8.19%. This is the amount by which the average investor underperformed the benchmark S&P 500 index that year. Longer term, the behavior gap is 4.66% — this is how much lower the average equity mutual fund investor’s 20-year annualized return was at the end of 2014 (5.19%) compared to the S&P 500 (9.85%).
The Recency Bias
So what are some irrational actions taken by investors that damage investment performance and lead to the behavior gap? One is having what’s referred to as a recency bias — or in other words, placing an overemphasis on recent events in their decision-making.
For example, when the markets are rising, many investors excitedly buy, and when the markets are falling, they despondently sell. This often leads to buying high and selling low — the opposite of a successful investing strategy.
Another irrational action is chase past performance. In other words, investors believe that if a mutual fund or asset class performed well last year, it will do so again this year. But there’s a reason why mutual fund disclosures state that “Past performance is no guarantee of future returns.” In fact, funds and asset classes that performed well last year are less likely from a statistical standpoint to perform well again this year.
Avoiding the Behavior Gap
So what can you do to keep from taking irrational actions like these and thus avoid the behavior gap? Here are 3 ideas:
- Don’t obsess over short-term fluctuations in your portfolio. If the past few years have taught us anything, it’s that the investment markets can be extremely volatile in the short term. Therefore, try to avoid checking your portfolio too often. Doing so may lead to emotional buy and sell decisions that damage returns.
- Make your saving and investing automatic. If you leave it up to yourself to regularly transfer money into your savings and investment accounts, you are introducing the human element into the investing equation. Instead, arrange for automatic transfers of money into your accounts each month. This is one of the most important keys to regular and consistent saving and investing.
- Create a comprehensive financial plan — and stick to it. Work with your financial advisor to create a big-picture financial plan that takes into account your long-term goals and objectives. Then when you feel tempted to make emotional investing decisions based on short-term market movements, go back and look at the plan to remind yourself that you’re running a marathon, not a sprint.
If you have more questions about behavioral finance, please give us a call. We’d be glad to work with you in creating a comprehensive financial plan that helps you avoid the behavior gap.