“It turns out my job was not to find great investments, but to help create great investors,” writes Carl Richards, author of “The Behavior Gap.”1 From increasing our budget mindfulness to taking a steadier approach to investing, Richards has drawn attention to the way our unexamined behaviors and emotions can be to our detriment when it comes to living a happy and financially sound life.
In many cases, we make poor financial decisions when experiencing panic or anxiety as a result of personal or widespread events. Below we discuss the common financial behaviors driven by such circumstances.
The Behavior Gap Explained
Coined by Richards, “the behavior gap” refers to the difference between a smart financial decision versus what we actually decide to do. Many people miss out on higher returns because of emotionally driven decisions, creating a gap — “the behavior gap” — between their lower returns and what they could have earned. The graph below2 demonstrates the emotions that many investors could feel throughout the course of an average market cycle and how emotionally driven investment decisions can lead to subpar returns.
4 Common Emotions that Can Create a Behavior Gap
#1: Excitement When Stocks Are High
Whether in a bull market or witnessing the hype from a product release, many investors may feel tempted to increase their risks or attempt to gain from emerging investments when stocks are high. This can lead to investors constantly readjusting their portfolios as the market itself experiences upswings. An investor who follows such patterns is likely to do the same with declines and may end up trying to time the market amidst its inevitable, unpredictable movement.
#2: Fear When Stocks Are Low
In response to market volatility, investors may feel the need to choose more secure investments and avoid uncertain or seemingly unsafe investments. When stocks are low, a common response may be to sell and effectively miss out on potential long-term gains.
#3: Engagement in the Search for Alpha
People yearn to make money and take action to do so. Throughout our lives, this emotional desire is likely a constant one. As such, many seek the help of a financial advisor to procure above-average returns, otherwise known as “alpha.”1 However, in this search for “alpha,” our humanness — our emotions and our behaviors — may lead us astray. Ironically, studies done by DALBAR have calculated the “average investment return” as compared to investor returns and have shown that investor returns are lower.1 The underlying emotional desire and pursuit of money is exactly the recipe for unwise behaviors in response to emotions — but only if left unchecked.
#4: Short-Term Anxiety and Focus
Viewing our lives through the lens of current circumstances is normal. And letting a moment consume us is a natural emotional response, especially if faced with grave consequences — from our personal health being compromised to the loss of loved ones. It's difficult in these times to think long-term. However, making a rash decision can inhibit the long-term benefit that comes from maintaining a balanced perspective without reactionary behavior.
How to Lessen the Behavior Gap for Your Financial Health
At any given point, the market can go up, down or it can remain the same. While many aspects of the economy and business cycle are out of our control, one thing we can control right now is how we handle our financial strategy. Remembering the likelihood of recovery over time — and the market’s nearly inevitable up-and-down movement — can provide a more logical angle to calm the nerves.
If you’re experiencing financial anxiety in response to market volatility, take a breath and also remember the potential for long-term gains. And if you are looking for an experienced team to help guide you through that emotional roller coaster, we urge you to schedule an introductory meeting with us.
- Source: https://www.marketdeskresearch.com/
- Source: Bloomberg, FactSet, Standard & Poor’s, J.P. Morgan Asset Management; (Bottom) Dalbar Inc, MSCI, NAREIT, Russell.
Indices used are as follows: REITs: NAREIT Equity REIT Index, Small Cap: Russell 2000, EM Equity: MSCI EM, DM Equity: MSCI EAFE, Commodity: Bloomberg Commodity Index, High Yield: Bloomberg Global HY Index, Bonds: Bloomberg U.S. Aggregate Index, Homes: median sale price of existing single-family homes, Cash: Bloomberg 1-3m Treasury, Inflation: CPI. *60/40: A balanced portfolio with 60% invested in S&P 500 Index and 40% invested in high-quality U.S. fixed income, represented by the Bloomberg U.S. Aggregate Index. The portfolio is rebalanced annually. Average asset allocation investor return is based on an analysis by Dalbar Inc., which utilizes the net of aggregate mutual fund sales, redemptions and exchanges each month as a measure of investor behavior. Guide to the Markets – U.S. Data are as of August 12, 2022.
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