Author: Brent Lemieux CFA® CPA

The behavior gap is the difference between the return a mutual fund earns and the return the average investor earns on that fund.  For example, let’s say fund x earned 10% last year and the average investor in fund x earned 8%.  In this example the behavior gap is 2% (10% – 8%).  While this is just an example, sadly it is the norm.

How is this possible?  How can investors earn less than the funds they invest in?

The answer: Doing the wrong thing at the wrong time.  Investors make a number of behavioral mistakes that harm their returns and the value of their portfolios.  Here are some common mistakes:

Trying to time the market.

Market movements are subject to so many factors that they are nearly impossible to predict.  Timing the market well is something most hedge fund managers can’t do well, so it is best that non-experts don’t even try.  Doing so will result in excess fees at minimum and could be even worse.

Chasing high performing funds and stocks.

It can be tempting to move money from one fund that’s underperforming to one that’s outperforming.  I’d caution against this.  Mutual funds and asset classes in general have mean reverting tendencies, meaning that the shooting stars typically fall back down to earth.  It’s often the case that the worst time to buy a fund is after it has had a good run.  It’s not rare for a top performing fund one year to find itself near the bottom the next.  However, as I cautioned in point 1, don’t try to time this.  Instead, create a well-thought-out investment plan and stick to it.

Selling assets when the market is in a panic.

It’s usually a bad idea to sell a fund when it has recently been performing poorly.  If we sell out at the bottom, we are locking in our losses, giving our investments no chance to recover.  And since funds revert to the mean, poor performing funds one period are often high performers the next.

 

Strategies to overcome the behavior gap:

1. Don’t look at your portfolio or investment performance. The less often you look at your investment accounts, the less likely you are to make behavioral investment mistakes.
2. Setup a systematic rebalancing strategy. Rebalancing allows you to keep your portfolios allocation in line.  Rebalancing in a systematic manner prevents you from buying high and selling low. We’ll have more to say about rebalancing next week.
3. Hire an advisor. An advisor can be an objective third party that stands in-between you and the wrong decision.  It’s sort of like when your friend asks for your advice about a family or relationship problem.  Because you aren’t completely emotionally invested in the problem, you can usually see the situation more clearly and provide sound advice.

 

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