The Behavior Gap and How It Can Affect Your Portfolio
Updated: Jan 18
Investing is an interesting topic because the data and methods seem fairly straight forward, yet we as humans complicate the matter. Easily one of our most notable roadblocks is the human mind. If you step back and think about it, we should invest low and sell high, yet our minds want us to sell low out of panic but buy into the market as it is rising with fear of missing out. Over the past 20 years from 1996 to 2015, the S&P 500 returned 8.2%. However, over the same period a Dalbar study has found that the average dollar invested in U.S. equity mutual funds returned 4.7%.
The reason for the gap between the two is related to poor purchasing and selling decisions, in conjunction with other factors such as higher expense ratios.
First, you will notice that the investor returns are lower than the fund returns, and this is due to the human mind wanting to run when the market is falling. When we see the market falling, the first thing to pop into mind is pulling our money out before we lose it all. However, it has been proven that attempting to time the market will result in lower overall returns.
This secondly leads into the debate of active versus passive investing, which both still have a strong indication of a behavioral gap. Rather than the style of investing, it appears that the behavior of the investor will dictate long-term success of your portfolio. Regardless if you choose active or passive investing, ultimately it is your behavior that will have a greater influence on portfolio returns. To mitigate any drawdown, the idea is you let your money grow and ride through the good, the bad, and the ugly times.
That being said, no matter your investing preference, it is critical that you do not sell out of fear, as typically this is the worst time to sell. Take 2007 and 2008 for example as the latest time many individuals exited the market. Should you have kept your money in the market, you would have recouped all loses and then much more. However, if you exited the market and attempted to time your re-entry, you likely left a solid return percentage on the table. The main takeaway is to stay disciplined no matter if you choose active or passive investing.
Lastly, should you find that you are your own worst enemy; it may benefit you and your portfolio to have a financial advisor. Utilizing a financial advisor can be great, allowing an individual to maintain your financial plan, ensuring that you maintain a disciplined approach. Also, should you need an opinion or research assistance, odds are your financial advisor can provide you with the necessary information.
No matter what you invest in or the approach you take, it will likely be your behavior that will influence your returns the most. In order to avoid this, ensure you keep your money working for you, through the good and bad times. Attempting to time the market will likely result in lost portfolio growth. With that, maintain a disciplined approach to your plan. Have confidence that what you are investing in and the plan you have compiled will work. Lastly, should you find yourself still struggling, look into hiring a financial advisor as they have the tools and means to keep your portfolio on the right track. The human mind is powerful, but should you learn to keep reactions at bay, your portfolio will benefit.