The behavior gap is the difference between the rates of return that investments produce when an investor makes rational decisions and the rates of return investors actually earn when they make choices based on emotions.
Learn how the behavior gap works and how to close it.
What Is the Behavior Gap?
In his book "The Behavior Gap, Simple Ways to Stop Doing Dumb Things With Money," financial planner Carl Richards uses the term “behavior gap" to describe the difference between the higher returns that investments tend to organically produce and the lower returns investors actually earn because of their own behavior.
Richards' behavior gap theory suggests that many investors earn lower returns not because of the investments they choose but because of the way they use those investments. If these investors behaved differently while still using these same investments, they might experience better results.
How the Behavior Gap Works
Richards posits that there is a difference between investor returns and investment returns. Specifically, he claims that the real returns that investors get are lower than the returns of the average investment.
According to MorningStar, rates of return for investors were slightly lower (by five basis points per year) than total investment returns over the 10-year period ending on Dec. 31, 2019. However, the behavior gap has narrowed.
This behavior gap stems from irrational investing decisions driven by the desire to avoid pain and seek pleasure in the form of above-average returns, referred to in the investment industry as "alpha." Such decisions include selling when investment prices are low or switching from one investment to another based on the pick of a stock analyst on television.
But rather than rewarding investors with alpha, such irrational decisions can lead investors to lose capital or buy investments when they're "high" or more expensive, which can ultimately lead to lower rates of return.
For example, let's say that you have 1,000 shares invested in AlphaTech, with a value of $1,000. The stock market crashes, and the share price is cut in half overnight to $0.50. You now have 1,000 shares worth only $500. Although you haven't yet realized any loss, you opt to sell all your AlphaTech shares the next morning, operating under the assumption that the price will fall further. But instead of falling, the share price climbs to $0.75 by the end of the next day and reaches $1.50 by the time the market recovers. As you sold your investment, you realized a loss of $500 and a rate of return of -0.5%, whereas you would have received a 0.5% return if you had patiently held onto the investment. The gap between the investor return and investment return is 1%.
Richards offers a plethora of sketches that provide poignant illustrations about investing behavior on his website, BehaviorGap.com.
How to Close the Behavior Gap
The difference between realized and average investment returns can be minimized by taking a disciplined approach to investing and relying on a logical process to make decisions. If you use a consistent, analytical approach, it should help you avoid making overtly emotional, reactionary decisions about investing during tough times.
There are several steps you can take toward that aim:
- Do your research: Invest some time in reading reputable financial magazines, newsletters, and books. That research should include an examination of trends both in the recent past and at earlier points in time when your finances were substantially impacted. In his book, Richards provides an anecdote about lawn mowing to explain the value of research when making investment decisions. If you mow the lawn without first figuring out where the sprinklers are, you'll run over the sprinklers. Similarly, if you invest without doing your research, you're not going to like the rate of return.
- Take a diversified approach: If you put all your eggs in one basket and lose, you could lose big. Diversify the asset classes (stocks and bonds, for example) and the industries and individual securities you invest in. Richards claims that being unhappy with at least one investment in your portfolio is a sign that you're diversified.
- Stick to your investment strategy: Richards notes that the rates of return touted in investment marketing materials are based on a buy-and-hold strategy of buying an investment once and keeping it over the long haul, but such a strategy isn't always implemented by investors, resulting in below-average returns. Rather than chase fads, switch to "hot" stock picks recommended by analysts, or sell low because you thought you could time the market, be patient and keep your long-term investments. Rebalance your portfolio as needed to maintain the desired asset allocation.
- Consult a financial planner: Using the services of a financial advisor or financial planner can provide a buffer between your emotions and the financial decisions you commit to. It can also help you avoid mistakes that lead to the behavior gap.
- Have the "overconfidence conversation": Richards coined this term to describe a talk investors should have with friends or family before making major money moves when they're overly confident in their own knowledge. Ask questions about whether you are right in making the change and how the change will impact your life, what will happen if you act and you're wrong, and whether you've been wrong before.
- The behavior gap is a term coined by financial planner Carl Richards that refers to the difference between real investor returns and average investment returns.
- The gap stems from irrational decisions motivated by a desire to avoid pain and seek pleasure and can lead to lost capital or buying investments when they're pricier, which can reduce returns.
- Doing your research, diversifying your portfolio, maintaining your investment approach, consulting a financial planner, and running your choices past friends on family, are all methods that investors can use to close the behavior gap.