“A simple rule dictates my buying: Be fearful when others are greedy and be greedy when others are fearful.”
Throughout life, there is often a disconnect between what we know we should do and what we actually do. Take dieting, for instance. Nearly all of us have fallen prey time and again to overindulging in savory snacks or sweet desserts, even when we’re well aware it disrupts our efforts to get healthier.
In the world of investing, this phenomenon has been dubbed the “Behavior Gap”. It is the difference between rates of return on investments by a rational actor and rates of return on investments by an emotional actor. By and large, investors have made significantly smaller returns than the actual markets they’re invested in due to self-sabotaging behavior. In other words, well-diversified portfolios containing high quality stocks will almost always outperform a hand-picked collection of stocks.
To evaluate the impact of the behavior gap Dalbar, a financial research firm, gathered data over three decades. On the one hand, they calculated average investor performance. On the other, they looked at the historical performance of the S&P 500. While it is less often cited than the Dow Jones Industrial Average, the S&P 500 is generally thought to be a better indication of overall market performance than the Dow Jones. The S&P 500 is an equity index based upon the performance of the largest 500 companies that are publicly traded.
According to Dalbar’s historic calculations, overall, since 1971 investments in the S&P 500 collectively have gained an average of about 10% in value a year. At that average rate, investments double in value approximately every seven years. In contrast, the average mutual fund stock investor’s invested assets grew only 4.1% over the same 30-year period, which means that the value would take about 17 years to double.
The most recent Dalbar study was released on March 31st of this year. It found that in 2021 the average investor earned about 10% less than the S&P 500 (18.39% vs. 28.71%). Of course, every individual year is unique, and 2021 was a much more difficult year for actively trading investors than 2020.
Much of the dangerous gap between emotional and rational investing decisions stems from our emotions. We often attribute our emotions to successful choices; after all, how often have you heard the phrase, “follow your gut?” However, when it comes to investing in the long term to reach your goals, your feelings often prove counterintuitive. Some of your strongest emotions — fear and greed — can tempt you to sell when your investments are low and buy when your investments are high.
There are some methods to limit the effect of the behavior gap on your net worth. Try a few of these and see if your portfolio’s performance improves.
Remember Historic Market Performance
When you’re tempted to buy or sell “on a hunch”, revisit articles like this one. There are plenty of them because history repeats itself. There will be years, maybe several in a row, when US investment markets perform terribly. They will undoubtedly be preceded and followed by a year or years of positive market performance.
Keep up the Mindfulness
Volatile markets cause investors a lot of anxiety, and stress affects your ability to think and act rationally. It’s no surprise, then, that stress can lead to emotional investment decisions and a consequent loss of wealth.
One proven way to reduce stress levels is to practice mindfulness. For more about the benefits of mindfulness and tips for beginning a mindfulness practice, see my 2016 article here.
Have a Strategy, and Stick to It
One of the best ways to avoid emotional investment moves is to have a written investment strategy. Begin with a diversified portfolio. Diversification applies both to classes of assets — stocks, bonds, real estate, etc. — and market sectors and industries. Once you have established a diversified portfolio, stick with it. You can periodically rebalance your investments to maintain your desired asset allocation but promise yourself that you will not let short-term market performance affect your long-term plans.
Engage a Professional Investment Advisor
Working with a professional investment advisor can help you avoid making emotional investment decisions by offering you well-structured investment management solutions. An advisor will get to know you and give you customized advice. She will help you come up with a strategy for diversification and remind you to stay focused on your long-term goals. And as your life changes your investment advisor will help you make sure your investments continue to further your goals.