In misbehaving saving me?
How many times has this happened to you? Some interesting new fund manager or ETF is putting up great numbers, sometimes for years, and you take the plunge and finally buy it. It's a hot fund with tremendous performance. But after a few years you review your portfolio and wonder, hey, how come my returns aren't nearly as good as expected. You may be experiencing what has become known as the behavior gap. It's the reason your actual performance is much
worse than the fund you purchase. I'm Barry Riddolts, and on today's edition of At the Money, we're going to discuss how to avoid suffering from the behavior gap. To help us unpack all of this and what it means for your portfolio, let's bring in Carl Richards. He's the author of The Behavior Gap, Simple Ways to Stop Doing Things with Money. The book focuses on the underlying behavioral issues that lead people to make poor financial decisions. So Carl,
let's just start with a basic definition. What is the behavior gap?
Thanks? Verry, super fun to chat with you about this. So I this is going back now twenty years right, like I just stumbled upon this early on in my work with investors that we would get all excited. I would get all excited as you, exactly as you said, like we would do some performance review. We would find some fund we thought was great. Of course, past performance
is no indication of future results. But what's the first thing you look at when you decide to make Yeah, past performance, get all excited about it, and then you have this inevitable letdown. And so I think the easiest way to describe this is imagine you open the newspaper and there's an there's an advertisement, Remember the old fashioned newspaper, right, There's an advertisement for a mutual fund that says ten year average annual return of ten percent. Well, that's the
investment return. And I think we all forget that investments are different than investors, and so the behavior gap is the difference between the investment return and the return you earn as an investor in your account. And my experience and the data show that often individual investors underperform the average investment. So it's this well intentioned behavior of finding the best investment is generating a suboptimal result for us as investors.
So what's the underlying basis for that?
Gap.
I'm assuming, especially if we're talking about a hot fund, the fund has had a great run up, people buy, if not the top, well certainly after it's had a big move, and then a little bit of mean reversion comes back into it. The fund does poorly for a couple of years and then kind of goes back to where it was. Is just as simple as buying high and being stuck with it low? Is it that simple?
Yeah, it's interesting. Let me just tell you a quick story, and this is about all great investment stories are about your father in law. Right, So I remember my father in law in ninety seven, ninety eight, ninety nine, he had an investment advisors was named Carter. I remember all this, and he owned and I can name specific funds because
these things are not the problem. The fund didn't make the mistake, right, So Alliance Premier Growth, if you remember ninety seven, ninety eight, ninety nine, just you know he owned Alliance Premier Growth, and he owned Davis New York Venture, so a go go growth fund and something that was classically value. And at the end of ninety seven he looks at his returns and he's like, why do we own this? This Davis this value fund. Why do we
own this thing? Carter talks him into rebalancing, which means he took some from Alliance Premier Growth it to Davis, opposite of what he felt like doing. Right. Ninety eight comes wrong, same thing, Alliance Premier Growth knocks it out of the park. Davis only does like twelve percent or something, right, father in law complains. Carter says, hey, please come on, like, this is just this is just what we do. We're actually going to do the opposite of what you feel.
We're going to sell some Alliance Premier Growth. We're going to rebalance into Davis ninety nine, right, And I can't call the exact numbers, but if I Alliance did something like fifty four percent and Davis only did seventeen, and my father in law was like, that's it, that's it. And I remember New Year, like over Christmas, over the Christmas holiday of ninety nine, right, and you know what happens next, he tells me, He's like, yeah, I finally
had enough. I fired those Davis, that Davis New York Venture Fund and moved all the money to Alliance Premier Growth just in time. You know, we had another He felt like a hero for January February and then March of two thousand, just in time to get its head taken off. And we repeat that over and over, and it's kind of wired into us. So's it's challenging. You want more of what gives you security or pleasure, and you want to run away from things that cause you
pain as fast as possible. And somehow we've translated that into by high and so low and repeat until broke. Huh.
And I happen to have the number one of that series of lithographs you did, repeat until yes, hanging in my office. And let's put a little a little meat on the bones if you were heavily invested in any fund that was heavily exposed to the Nasdaq from the peak in March two thousand to just two years later. By October of two the Nasdaq was down about eighty one percent pete to troth. Yeah, that's a hell of a haircut, losing four fifths of the value.
Especially just I mean, I remember those conversations like there was I mean, this is kind of fun to poke fun at your father in law, right, but it wasn't very fun when there was like some pretty major drastic changes in the way the family was operating because of that experience, Like it was, it was a real deal for lots of people, right sure, because that was and and Barry just to point out, like that was not
an investment mistake, that was an investor mistake. Right. If you had just stuck to the plan, which is rebalance each year, you would have been fine. It would have been painful, but not nearly as painful as it turned out to be.
And I would bet the Dave's Value Fund did pretty well in the early two thousand, certainly relative to the growth fund for sure.
For sure, So you would have been protecting that. You would have been systematically buying relatively low and selling relatively high along the way systematically, because it's just what you do, and that's called rebalancing.
So the behavior gap creates this space between how the investment performs and how the investor performs. How big can that gap get? How large does the behavior gap between actual fun performance and investor returns become?
Yeah, this is really problematic because there are a couple of different studies and none of them are great. My experience with it is more antidotal, right, Like the experience I have, like the story I just told, I could tell twenty of those stories, right given, I mean, did anybody listening become a real estate investor in No? Seven? Right? Like over, you know, we don't have to even go into the crypto NFT situation, right, but just over and over we do it. But morning stars numbers I think
are my favorite, and that always puts it around. It's a percent, a percent and a half over long periods of time, which when we're all scraping for twenty five basis points, you know, running around trying to eke out the last bit of return, then this behavior gap that costs us one hundred and twenty you know a point to a point in a quarter is something worth paying attention to.
Yeah, especially as as how that's compounded over time, it can really add up to something substantial. So let's talk about where the behavior gap comes from. It sounds like our emotions are involved. It sounds like fear and greed is what drives the behavior gap. Tell us what you've found.
Yeah, I originally it's funny when I originally this was sort of I felt like this was a discovery, you know, cute of me because lots of other people have been writing about it for years. But I was trying to put a name on this gap, and I called it originally the emotional gap. I'm really glad I changed the name to the behavior at for the book. But to me, there was just I couldn't explain it other than or
invest behavior. And I think when we understand how we're wired, and I can't remember who was a Buffett that said, of course we could just we can always attribute it to Buffett if it was smart. But it was. If you want to design a poor behavior, a poor investor, design a human right, we're we're hard wired and it's kept us alive as a species to get more of the stuff that's giving us security or pleasure, and to run as fast as we can. Like I don't really care, Berry,
I don't care what you tell me. If my hand's on a burning stove, I'm going to take it off. There are all the facts and figures you want at me. Try to be rational with me all day long. I'm I'm taking my hand off. And somehow, especially given the sort of circus that exists around investing, you know where you got people yelling and screaming by sell buy sell all day long. We translate market down, mark it down.
Oh no, if I don't do something, and we project the recent past and definitely in the future, and I've seen people actually do the ca oculations. If the last two weeks continue, in fifty two weeks, I'm gonna have no money left, right, so market's going to zero. Yeah, we have this recency bias problem. We have being hardwired for security and pleasure. We have safety heard behavior when all your neighbors are yelling, right, it's really hard not to,
you know. And it was a buffet quote. Right, I want to be greedy when everybody else is fearful, and fearful when everybody else is greedy. And that's cute to say, But when you've actually been punched in the face, you behave a little differently, right.
So the other thing that I noticed that you've written about regarding the behavior gap is how much we focus on issues that are completely out of our control. What's happening with markets going up and down? Who is Russia invading? What's happening in the Middle East? When's the FED gonna cut or raise rates? All of these things are completely outside of not only our control but our ability to fore cast what should investors be focusing on instead.
Yeah, I think portfolio construction, when done correctly, it takes into account the weighty evidence of history, and the weighty of evidence of history includes all of those events that we couldn't have forecasted before, So we shouldn't be surprised that things that we didn't think about will show up next year, next week, and those things that we didn't think about will have the greatest impact on our portfolio. So it's literally like the unknown unknowns that will have
the greatest impact. Will design the portfolio with that in mind, Well, how do you do that? We'll use the weighty evidence of history because it's been going on for a long time. So I think the way to focus on what, like the thing you can control the most is portfolio construction, asset allocation and costs. Like if we just get clear about that the portfolio is designed. Here's a question ask you. I've been asking this question as like a game for
the last five years. Why is your portfolio built the way it is? And the most common answers like I heard about it on the news. This really smart people whisper everything about it. An economist, right, so you, But the correct answer is this portfolio is designed intentionally to give me the greatest chance of meeting my own goals. Well, those are the things you can focus on. Huh.
Quite intriguing. So to wrap up, when investors chase hot funds or ETFs or sectors or whatever is the flavor of the moment, there's a tendency to buy high, and if subsequently they get out of these positions or sell into a panic or market correction, they're all but guaranteed to generate a performance worse than the fund itself. To avoid succumbing to the behavior gap, you must learn to manage your own behavior. I'm Barry Ritolts, and this has
been Bloomberg's at the money. Ain't misbehaving, I'm saving my value.