How The Behavior Gap Affects Your Investments
“It turns out my job was not to find great investments, but to help create great investors,” writes Carl Richards, author of the book 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 work our detriment when it comes to living a financially healthy and happy life.
In many cases, stress or panic as a result of personal (or more general) events can lead us to make poor financial decisions. In the past few months, the Coronavirus has affected nearly every industry and home as people and governments take action to keep themselves and their communities safe. The virus continues to evoke fear as the number of affected individuals continues to rise.
The effects on the stock market began in late February but commanded greater attention on Monday, March 9, the date of history’s largest point loss for the Dow Jones Industrial Average. New record losses came again on March 12 and March 16, 2020, underscoring the financial effect of this health crisis.2
Whether facing a frightening development or an exciting advancement, people frequently make money decisions in response. Richards coined the term behavior gap to refer to the difference between a well reasoned financial decision versus what people actually decide to do. Many people miss out on higher returns because of emotionally driven decisions, creating a gap between their lower returns and what they could have earned if they’d acted rationally instead.
Four Scenarios that highlight the Behavior Gap
#1: Excitement When Stocks Are High
Whether it’s due to a bull market or the hype from a product release, many investors feel tempted to increase their risk or attempt to gain from emerging investments when stocks are high. This excitement can lead to investors constantly readjusting their portfolios as the market itself experiences upswings, causing investors to buy at or near a market peak.
#2: Fear When Stocks Are Low
During a time of instability, like a pandemic or civil unrest, many investors feel the need to choose more secure investments to avoid seemingly unsafe choices.
When stocks are low, a common reaction is to sell. This does nothing more than to lock in losses, and sets up the investor to miss important opportunities for later gains.
In the market’s inevitably unpredictable movement, the results are usually bad for investors. These first two behaviors often work together to cause some investors to buy high and sell low, buying in times of excitement and selling in reaction to fear.
#3: Searching for Alpha
The desire to achieve an advantage, such as by maximizing profit, is understandable. Many seek the help of a financial advisor hoping to secure above-average investment returns, known as alpha. However, Richards notes that in this search for alpha, human emotions and behaviors often lead investors astray: studies have calculated the average investment return is greater than that achieved by the average investor. The underlying emotional pursuit of profit, if left unchecked, is precisely the recipe for unwise behaviors in response to emotions.
#4: Short-Term Anxiety and Focus
It’s normal for all of us to see our lives through the lens of current circumstances. We should, however, avoid letting the moment consume us, especially when faced with grave consequences—from risks to our own health to the loss of loved ones. Many may find it difficult in these times to think long-term while staying calm and rational. Making a rash decision can inhibit the lasting benefits that come from maintaining a balanced perspective.
How to Lessen the Behavior Gap for Your Financial Health
At any given moment, the market’s next moves could be up or down (or, rare as it may be, it can remain the same). And while many aspects of the Coronavirus are out of our control, we can control our response to the news we read and hear.
Remembering the very strong likelihood of recovery over time—and the fact that the market is inherently unpredictable in both good times and bad—can provide a more logical perspective to help calm your nerves.
If you’re experiencing financial anxiety in response to the pandemic, take a breath and remember the potential for long-term gains. Of course, you can and should always reach out to your advisor for further clarification and guidance.
1 https://behaviorgap.com/outperform-99-of-your-neighbors/
2 https://www.nytimes.com/2020/03/16/business/stock-market-today-coronavirus.html