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 What does behavior gap mean? Studies have shown that unforunately, emotions play a funny trick when investing. The term, coined by our friend Carl Richards of BehaviorCap.com, is very adequately put. More often than we want to admit, investors tend to do the following:
- Purchase the funds that are doing the best at the time (buying high)
- Jump to cash or bonds after the market has slumped (selling low)
- Chase the returns of funds...after the returns have already happened
- Follow the advice of the talking heads on CNBC, PowerHour, or Jim Kramer (it's only advice, as you can see below)
"The investment firm Charles Schwab recently compared 2006 results for two sets of workers—those who picked their own 401(k) mutual funds and those who followed simple forms of advice that were offered by their plans. The advised accounts did better than the do-it-yourselfers by roughly 3 percentage points a year. That's huge, compounded over 20 or 30 years. What made the difference? Mostly, smarter diversification."
- Jane Bryant Quinn,
January 12, 2008
A Normal Scenario
Let's say you just opened your quarterly statement, and found the funds in your account performing well, but not as well as the International or Emeriging Markets funds in your plan. So, why not? You throw 30% of your funds, those that performed the worst, into the International and Emerging Markets funds.
Three Months Later...
You open up your statement after monitoring it throughout the quarter about 3-5 times (hard to remember, was a busy quarter), and your funds did well! In fact, they were among the top performers in your account! There's no reason to change, as if it's not broken, why fix it? Right?
12 Months Later...
Unfortunately, after checking your quarterly statement in depth for the first time in longer than you want to admit, you find that the funds in your plan have dipped significantly. In fact, they are negative...big time. And which funds are leading the way? International and Emerging Markets. Were they bad funds? Short shelf life? You did some research, and they were both 4 and 5 star funds. So what should you do?
"...the S&P 500 (10.2%) and the average fund manager (12.2%) has outperformed theaverage investor (2.7%) over the past 30 years. Why? Because, individuals who handle their own accounts tend to make too many moves and at the wrong time greatly retarding long-term performance. The point being that unless you own managed funds or index funds, you will not achieve any where close to the returns used in research reports comparing stock market returns to other asset class returns over a long period of time.
Also, according to studies by DALBAR, the majority of investors put their money into mutual funds when markets are relatively high, and either sell or stop investing when markets are low. Intellectually we know that’s backwards but emotions are much stronger than our intellect. Dalbar’s long term studies indicate that the average investor makes about 60% less than the market. And much of that difference is the result of wanting to find somewhere safe to invest when the market goes down." - Larry Nasbaum
The Reality
Unfortunately, we see this all of the time. Were the funds bad? No. Instead, the areas in which they were invested performed poorly over that period of time. Did the 401(k) investor put too much money in them? Maybe. Did it affect how much risk was in his portfolio? Absolutely. Greed and fear tend to drive more decisions in investing than they should, and thus buy high, sell low behaviors continue to have a dramatic effect on investment returns.
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