The Behavior Gap

Research firm DALBAR‘s “Quantitative Analysis of Investor Behavior” has because somewhat famous for showing that in terms of performance results, investors tend to be their own worst enemy. For instance, for the 20-year period ending in 2010, the annualized return of the S&P 500 was 9.14%, while the average equity fund investor gained only 3.83% per year.

The news was worse for bond investors. The average fixed income fund investor was up only 1.01% compared to 6.89% from the Barclays Aggregate Index, a difference of over 5%.

Why is it that investors underperform the market?

One explanation of this phenomenon is what is referred to as “The Behavior Gap,” which states that psychological factors cause the disparity between returns earned by actual investors versus market benchmarks.

Indeed, investing goes beyond numbers and information management – there is clearly an emotional aspect as well. Just as people become fearful when the markets plummet (and sell at the very bottom, thereby permanently impairing their capital), they also get caught up in the cycle of “buy, buy, buy” during rising markets, entering the market when prices are often at their peaks.

The Behavior Gap

This behavior gap psychology has been particularly evident during the first half of 2013. As markets climb to new highs, many investors are increasingly focusing on relative returns (how a portfolio is performing against the stock market) instead of absolute returns (whether a portfolio is earning the annual rate of return that has been targeted). Sophisticated investors and advisors know that chasing stock market returns is a fool’s game, and that the key to success in investing is in consistent absolute returns and downside protection.

The bottom line is that in investing, patience is always key, whether that is avoiding the urge to “buy, buy, buy” in up markets or staying the course even when markets are at very depressed levels. It was less than five years ago that we were counseling clients to not give up hope that the financial markets would ever recover. Now, we are urging clients to resist the urge to focus on short-term, relative returns.

Warren Buffet perhaps said it best: “Be fearful when others are greedy, and greedy when others are fearful.”

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