What is The Behavior Gap?

Make better financial decisions by understanding the behavior gap.

Confused guy suffering from the Behavior Gap.
Emotional responses to what is happening in the markets can lead to a lower rate of return.. mage Source

There is a gap between the rates of return that are earned in the markets when an investor builds a diversified portfolio which is rebalanced in a responsible manner, and the rates of return earned by investors who move their money around in an emotional response to what is happening in the markets. 

The investors who let their emotions take control and move their money around earn lower returns. These results, documents by Dalbar, a research firm, show that average investors earn below average returns.

Carl Richards, an author, artist and financial advisor, coined the term “behavior gap" to describe this gap between the higher returns investors could earn, and the lower returns they actually earn because of their own behavior. He realized 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 would experience better results.

Behavior gap artwork and book

You can learn how to avoid falling victim to your own behaviors in Carl Richard's fabulous book titled The Behavior Gap, Simple Ways to Stop Doing Dumb Things With Money. I highly recommend it. He also offers a plethora of excellent sketches that provide poignant illustrations about our choices, which you can view and purchase at his Behavior Gap website. His sketches are often found in financial planning offices around the country.

Academic work on the behavior gap

Many forms of financial behavior gaps have been documented by the field of study called Behavioral Finance or Behavioral Economics, and in 2002 this field of study gained momentum when Daniel Kahneman was awarded the Nobel Memorial Prize in Economics for his work around financial decision making.

To be a good investor you must learn more about behavioral finance. By understanding your own behavior and subconscious tendencies you can improve your financial decision making. A popular book on the subject,Nudge, a New York Times Best Seller, can offer great insight into how your own mind can trick you into making financial decisions that are not to your benefit. 

Avoiding the behavior gap

You can avoid many financial mistakes by following a disciplined approach to investing, and by having a logical process you use to make financial decisions. If you use a consistent analytical process to make decisions, it helps you avoid making overtly emotional, knee-jerk decisions about investing during tough times.

Can a financial planner help avoid the behavior gap?

Using the services of a financial advisor or financial planner can provide a buffer between your emotions and the financial decisions you make, and may also help you avoid mistakes caused by the behavior gap.

Amazingly enough there is even a behavior gap around the understanding of what a financial planner does, so before you seek services, take the time to learn the difference between financial planning, investment advice and retirement planning.

Each is a distinct service and requires a different type of expertise. 

The most powerful tool you have

You have a powerful tool at your disposal that can help you make better financial decisions: it’s your ability to learn and educate yourself. Don’t waste your hard earned money by making poor financial decisions. Invest time in reading reputable financial magazines, newsletters, and books.

Continue Reading...