The uncertainty inherent in all investments awakens emotions that play a role in our investment behavior. Greed, overconfidence, and the need to control outcomes can lead us to suboptimal investment choices, the so called behavior gap. Instead of controlling outcomes, the solution to uncertainty is to rely on an investment framework that helps us control our behavior.
Let’s face it, as much as uncertainty makes life interesting, we don’t always like it. Uncertainty awakens many emotions in us, positive and negative. One is our uneasiness with the lack of control. We just have to do something to reduce or control uncertainty. Another one is overconfidence. We think we can control uncertainty better than other people, just as 80% of people think are better than average drivers. Our greed often fuels both these emotions. Uncertainty also plays on our fears, with the opposite effect of greed. When our fear is high, we tend to question our choices, sometimes to the point of regretting some. Fear increases our stress and the feeling of anxiety, which affects the quality of our lives.
Emotions and investing
What does this have to do with investing? A lot. All investments are characterized by uncertainty, and emotions play a role in our investment behavior. Greed, overconfidence, and the need to control outcomes may lead us to make suboptimal investment choices, some of which we reviewed here. Fear, on the other hand, can make us question our previous investment choices. This is how it works. We are proposed an investment strategy that has worked well in the recent past and we buy in. Because of the recent good performance, the price of the strategy is relatively high. When returns aren’t what we expected, we question the strategy, and we get out. Right when the price is low. And we repeat the pattern with a new strategy. Our timing in and out of a strategy creates a performance drag in addition to the bad overall performance of the strategy. Our investor returns are lower than investment returns (the returns on the actual investment) because of our behavior.
The behavior gap
The difference between investor and investment returns due to poor investor behavior and timing is called the behavior gap. The behavior gap can be large. In one important study, researchers at the University of California report evidence that overconfidence among stock investors leads to excessive trading. In their sample, investors that traded most earned an annual return of about 11% percent, while those that traded infrequently had returns of 18%, similar to market returns.
Show me the evidence
Similar to the cited studies, an analysis with investor data by Betterment shows that investors that change their asset allocations more frequently experience a larger behavior gap. The behavior gap is so prevalent that there are at least two well known annual studies of it, the Dalbar and Morningstar studies. As famous investor Benjamin Graham observed
“The investor’s chief problem—and even his worst enemy—is likely to be himself.”
Benjamin Graham
It affects all of us
It’s easier to measure the behavior gap with stocks, bonds, or mutual funds, because we have readily available data. But we know bad behavior isn’t limited to the trading of these investments. The source of the problem is uncertainty, both about returns and about the choices we make. Every time we make an investment that is not fully transparent or we don’t fully understand we are going to be subject to the effects of uncertainty. Think about private equity, alternatives, real estate, or [your most memorable investment experience here]. The behavior gap can affect both bad and good investment ideas. For example, it can affect us when we take more risk than we can handle, or if we hold investments that are not aligned with our goals. The reality is that we are all subject to the gap. If you think you got it under control, you may be overconfident, and I challenge you to get financially organized to see it.
It is no surprise then that behavioral coaching, helping investors avoid mistakes like poor strategy selection and timing, is one of the primary benefits of working with fee-only financial planners.
Now the good news
The investor gap is mainly driven by our emotions. The desire to control uncertainty, overconfidence in our ability to select winners, greed, fear, and regret. The good news is that there is a way of investing that reduces the effect of emotions on our choices. Decades of research in financial science show that we don’t have to rely on supernatural predictive abilities to benefit from what financial markets have to offer. It all starts from having the right core framework. Start by asking why you are investing, and set goals that are meaningful to you. Develop investment guidelines that work for your situation and given your goals. Use the guidelines to set a strategic asset allocation for you.
Controlling your emotions in times of high uncertainty or lower than expected return is never easy. But the right framework can make it easier and will help you avoid costly mistakes. You do not have to do this alone either. A trusted expert can help you gain the confidence that your investment strategy is right for you, so you can sit back and devote your time, energy, and skills to what matters most for you.
Until next time!
Massi De Santis is an Austin, TX fee-only financial planner. DESMO Wealth Advisors, LLC provides objective financial planning and investment management to help clients organize, grow and protect their resources throughout their lives. As a fee-only, fiduciary, and independent financial advisor, Massi De Santis is never paid a commission of any kind, and has a legal obligation to provide unbiased and trustworthy financial advice.
