THE BEHAVIOR GAP

WHAT IT IS AND WHY IT MATTERS

January 14, 2016

It has been the case throughout the history of investing that the vast majority of investors do not do as well as the market.  Moreover, they do not do as well as an individual stock, bond, mutual fund or index ETF that they may own or have owned.  The behavior gap is an especially interesting phenomenon when one looks at investment returns on index funds or ETFs, and the average returns of investors holding them.  The “behavior gap” was coined by New York Times writer and investment educator Carl Richards.  It is simply the difference between market returns and the returns of the average investor.  Does it matter?  Yes, it does.  It matters a lot.

Some recent commentary in The Globe and Mail cited a recent study by Dalbar.  The research looked at just how wide the behavior gap can be (and probably, for the most part, generally is).  A twenty-year annualized return of 8.7% was realized on a fairly balanced indexed portfolio – 60% U.S. stocks (S&P 500) and 40% bonds.  That is a good, solid return on such a balanced portfolio.  The problem, though, was that the average annual return of the average investor using that asset mix over the same period of time was 2.5%.  That’s right – the average investor left approximately 70% of gains he or she could have realized on the table.

There are a lot of reasons for this gap – markets are becoming ever more complicated, many investors think they can do better than experts and thus do not seek investment advice, etc.  But really, the behavior gap can be fully explained in two words:  fear and greed.  Human nature is what it is, and those emotions will never change.  The only way for an investor to reduce (or ideally eliminate) the behavior gap is to take control of those emotions.  I am sure many of you have heard the oft-repeated quote from Warren Buffett:  “be greedy when others are fearful and fearful when others are greedy.”  Obviously Mr. Buffett did not become one of the wealthiest people in the world by allowing himself to be controlled by emotions.  And while his words certainly ring true, those who can really achieve that level of discipline on their own are few and far between.

The sad fact is that the average investor is greedy when others are greedy and fearful when others are fearful.  The inevitable result is that they are generally “buying high” and “selling low.”  When such emotion-driven investors find themselves dealing with portfolios in the current high-volatility market environment, trading tends to increase with every spike up and down and the behavior gap becomes even larger.

As mentioned off the top, the behavior gap is nothing new.  We had seen it for many years and wanted to come up with a methodology that would help us and our clients turn off the siren songs of fear and greed and provide a discipline where any changes within a portfolio were dictated by mechanics and not emotion.  We believe (and our experience over more than a decade with our model portfolios has supported that belief) that the simplest way to eliminate the behavior gap is to have, and use, a regular and disciplined portfolio re-balancing mechanism.

What our rebalancing system does is essentially do what Mr. Buffett was suggesting.  But we don’t have to think about it.  There is no emotional angst.  A perfect illustration is what happened in the last bear market, where most of the decline came in 2008 and the first two months of 2009.  All of our model portfolios have equity and income components.  So, when the market decline resulted in equity positions being underweighted, the re-balancing process added new funds to equity positions.  We were buying low.  We don’t try to time the market.  We just let it tell us what to do.  In many areas of life, sometimes a very simple solution is the best one.  I think that is the case with respect to helping to close the behavior gap.

Howard Goodman
President, HG Partners Limited
Director, Private Client Group &
Senior Financial Advisor,
HollisWealth Advisory Services Inc.

This article was prepared solely by Howard Goodman who is a registered representative of HollisWealth Advisory Services Inc. (a member of the Mutual Fund Dealers Association of Canada and the MFDA Investor Protection Corporation).  The views and opinions, including any recommendations, expressed in this article are those of Howard Goodman alone and they are not those of HollisWealth Advisory Services Inc.

HollisWealth is a trade name of HollisWealth Advisory Services Inc. ® Registered trademark of The Bank of Nova Scotia, used under license.

HG Partners Limited is an independent company. Scotiabank companies have no liability for activities outside of HollisWealth.