Mind the Behavior Gap
When it comes to investing, maximizing risk adjusted returns and achieving desired financial outcomes is the ultimate goal. However, investors are often hindered by a phenomenon known as the "behavior gap." This gap refers to the difference between the returns of an investment portfolio and the returns that an investor actually receives after accounting for the impacts of their emotions and behavior. Morningstar found that fund investors earned a 9.3% investor return (which reflects the impact of cash inflows and outflows on the returns investors actually earn) over the 10 years ended Dec. 31, 2021, while their fund holdings generated an 11.0% annual total return over the same period. Thus, investors suffered a 1.7-percentage point annual return shortfall or “gap”.
The behavior gap is caused by poorly timed purchases and sales of fund shares, which cost investors nearly one sixth of the return they would have earned if they had simply bought and held their investments. This gap is persistent and has been found for the four previous rolling 10-year periods, making cash flow timing one of the most significant factors that can influence an investor's end results, along with investment costs and tax efficiency.
To avoid these gaps and capture more of their fund investments' total returns, investors can focus on several key strategies. Firstly, holding a reasonable number (generally 5 to 12 depending on the situation) of widely diversified funds is a great way to minimize risk in your portfolio while not making things overly complicated. By spreading your money across different asset classes, you can reduce your exposure to any one particular company, region, sector, or asset class. Secondly, automating routine tasks like rebalancing can help you avoid the temptation to make emotional decisions based on short-term market movements and temptations to speculate.
Morningstar’s study also found that investors should avoid narrow and highly volatile funds (these funds had the widest behavior gap) and embrace techniques that put investing on autopilot, such as dollar-cost averaging. This is particularly true for those who are in their working years and investing their saved cashflow. Dollar-cost averaging is the practice of investing a set amount of money at regular intervals, regardless of market conditions. This helps smooth out short-term volatility and can reduce the impact of the behavior gap on your overall investment returns. Lastly, it's important to pay attention to the fees you're paying for your investments and consider lower-cost options where appropriate. The underlying management fees on various funds or ETFs can seem insignificant but the difference between a 1% annual fee and a 0.15% annual fee for example can be magnitudes different over long periods of time. When significant amounts of money are involved, this can be hundreds of thousands of dollars over time. This is a large reason why Borges Financial has made a commitment to charging a flat fee for services rendered as opposed to the traditional 1% of asset under management fee model that is common place in the industry.
In conclusion, the behavior gap is a real hurdle for investors to overcome, but there are steps you can take to minimize its impact. By focusing on widely diversified funds to build an appropriate strategic asset allocation, automating periodic investing and rebalancing, avoiding narrow or highly volatile funds, and paying attention to fees and tax efficiency, you can increase your chances of achieving your investment objectives over the long run. By avoiding emotional decisions based on short-term market movements and staying disciplined, you can help minimize the behavior gap and achieve better investment outcomes.
We at Borges Financial provide independent comprehensive financial planning and investment management for a flat fee. Reach out to us for a complimentary introductory call if you would like to explore our services further.
