Mind the ‘behavior’ gap
Many investors fixate on the S&P 500 as a benchmark for their returns. It is widely recognized and used frequently by the media pundits. When it has a good year like 2014, people look at their diversified portfolio and lament “I didn’t beat the benchmark.” In reality, this is a GOOD thing. If you outperformed the S&P last year, you are probably taking too much risk and could very likely succumb to the “behavior gap.” We have become programmed to dwell on the performance of the high-profile benchmarks. It can and will hurt us.
Carl Richard’s, a contributor to The New York Times and author of “The Behavior Gap — Simple Ways to Stop Doing Dumb Things with Money” defines the behavior gap as the difference between investment return and investor return. Studies done by Dalbar, Inc. show that year after year, investors don’t do as well as their investments. Roughly speaking, if the markets provided average annual returns of 11 percent over a 20 year period, people investing in the markets saw a 4 percent average annual return. What happened to the 7 percent? Behavior seems to be the culprit.
Dr. Daniel Kahneman won the Nobel Prize in economics in 2002 for his work around behavioral economics. In their body of research his group shows that economic and financial decisions are often neither rational or efficient. They look at emotional “framing” which includes “optimism bias”, causing investors to believe they are less at risk of having negative outcomes than others. For example, if you have had your entire portfolio invested in U.S. domestic equities over the past few years, you have seen tremendous returns. With optimism bias, you are less likely to rebalance your portfolio to a properly diversified allocation and open yourself up to increased volatility. The cost of your mistakes will rise proportionately to your level of overconfidence! As we experienced in 2008, investors exposed solely to domestic equities experienced tremendous losses as the capital markets navigated the global crisis. The heat got intense and even though we are told to “hang on”, the pain of loss exceeds the pleasure of a gain of equal value and many sold out. Ah — falling into the behavior gap!
Don’t put your eggs in one basket! By managing diversification within a portfolio, you are creating portfolio efficiency. You want to get the most reward at your given risk level by minimizing uncompensated volatility. We want to create a portfolio that reduces the potential pain to something that you can manage when the next downturn happens, while still giving you potential for reasonable growth to overcome inflation and accomplish your goals.
Do you manage your own portfolio? Do you compare yourself, your investment manager or financial advisor’s performance to market benchmarks? This could lead you to chasing returns, as well as set you up for a volatile ride and disappointment with yourself or your advisors.
Your target return should include a combination of many things. Optimal portfolios need to consider time horizons for each of your reasonable goals, other sources of income, loss aversion perspectives, longevity of goal, and tax implications to name a few. Are you on track to reaching the financial stability and accomplishing what is important to you? Who is walking alongside you to manage the emotions of the market and keep you from falling into behavior gap?
Danielle Howard is a Certified Financial Planner practitioner. Her office, Wealth By Design LLC, is in Basalt. Visit her at http://www.wealthbydesign4u.com. Advisory Services offered through Cambridge Investment Research Advisors Inc., a Registered Investment Advisor. Securities offered through Cambridge Investment Research Inc., a broker/dealer, member FINRA/SIPC. Cambridge and WBD are not affiliated.
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