In recent years, the idea of a behaviour gap in investing has become commonplace. Although there are several ways of defining what this actually means, it is most typically used to describe the cost of our poor investment decisions.
The difference between potential and realised returns. While this might seem intuitive, for me it is quite an abstract and almost ephemeral concept – it is hard to really know what our ‘potential’ returns are and therefore how to close the gap.
Many conversations around addressing the behaviour gap often seem to assume that our aspiration should be to behave as if we are a super-rational, all-seeing and all-knowing decision maker. I am sorry to say that we will never reach this state, and judging ourselves against this ideal is wholly unhelpful.
Most of us will also be unable to avoid the decision-making challenges that blight investing by going for thirty years without touching our portfolio. This might be a sensible approach, but such stoicism is an entirely unrealistic expectation for most of the humans I have met.
We should not be aiming to be the perfect decision maker nor someone who rarely ever makes a decision. Instead, our focus needs to be on avoiding major, consequential mistakes.
When thinking about a behaviour gap what investors should focus on is the difference between the outcomes we might achieve by making reasonable choices and what we end up with after making some very bad choices.
All most investors really need to do is make some reasonable decisions over time and they will be just fine.
There is no ideal set of choices that we can make (except with the benefit of hindsight), and striving for incredible outcomes is often the cause of our worst decisions.
After the fact there will always be better choices we could have made. We will also always make decisions that have disappointing results. That is inevitable and perfectly acceptable. These really won’t matter that much – it is the big mistakes that will count.
And what do these major mistakes look like? Not investing at all, selling equities near the trough of a market decline, abandoning investment principles to participate in a mania or bubble, constantly switching between assets or funds as performance waxes and wanes, becoming concentrated in a particular fad, theme or trend, I could go on…
While these are different types of mistakes they are all driven by our behaviour and all have the potential to incur significant costs that compound over time. I think there are three key features of financial markets that make them so common:
The power of stories: Humans interpret the world through stories, and financial markets are narrative generating machines. When we make poor investment decisions, they are inevitably deeply intwined with a story we are using to interpret a complex and chaotic environment. It is easy to look at historic financial market events with equanimity because we know how these stories unfolded; it is an entirely different proposition when we are in the midst of an event – because we don’t know how the story will end. So, we make up our own ending and invest accordingly.
The passage of time: It is easy to look at the impressive returns delivered by equity markets when investing over 20 years, we can do that in a second; that in no way prepares us for the challenges of living through those 20 years to receive those returns. In investment theory time is nothing; in practice it is everything. We have plenty of time to make bad decisions.
The pull of emotions: Almost all our investment decisions are driven by our emotions. The problem with investment theory is that it is anodyne – it provokes little feeling. Think of the difference between knowing that equity markets from time to time will suffer from declines of 30-40% (or more) and then experiencing such a loss – they are not comparable in any useful fashion.
Our desire to tell stories to deal with uncertainty, the sheer length of time over which we invest and how emotions dominate our decision making all combine to create the real and costly behaviour gaps. What can we do about it?
Unfortunately, there is no sure-fire way of avoiding the gap, but I think there are five steps that can help us avoid the worst outcomes:
1) Make decisions by design: As far as possible we should design our portfolios to mitigate the issues that cause severe mistakes. Sensible diversification is essential, as is a disciplined approach to rebalancing and regular investment. Don’t design a portfolio based on investment theory alone, design it based on the realities of investing over the long-run and the challenges that brings.
2) Set clear and realistic expectations: Being open and honest about what investing over the long-term might look like is absolutely vital. Surprises are an inevitable cause of poor decisions. We won’t know what will cause the next bear market, nor where the next bubble will occur, but we know that they will happen – so be explicit about it. We should be saying: “at some point I expect equity markets to lose 40%, and this might see your portfolio value fall by £%, but this is to be expected and won’t stop us meeting our long-term goals”. It is far easier to avoid these conversations and focus on the long-run return of equities over time but setting expectations correctly so that when certain things occur in markets we can say: “this is what we discussed” is invaluable.
3) Get the framing right: How we frame something matters far more than we think it should, and we must use that to our advantage. Equity market declines can be viewed as a disaster, as a material loss of value and a prelude to even worse times. Alternatively, they can be framed as the price of admission – the reasons long-run returns are so high – or an opportunity to add to our portfolios at more attractive valuations. For long-term investors, it can also be helpful to frame near-term volatility as a concern for short-term investors – and that is not what we are.
4) Control our environment: Although in a cold state we might think that we can control our behaviour through time, the chances are that when stressful periods arise, we will make irrational choices. The best way to deal with this is not to think that we can re-wire our psychology but rather take ourselves away from the cause of the stimulation. If we are removed from the day-to-day fluctuations of financial markets, then many of the main causes of our major mistakes just fall away. Taking ourselves out of the environment is essential – if we don’t want to drink alcohol then avoiding the bar is usually a sensible step. Stop checking our portfolio values, don’t download the app and don’t read financial market news. Given how the industry wants us to engage in all these things it is hard to escape it, but if we can, it is likely to greatly improve the chance of good outcomes.
5) Have implementation intentions: Making plans for how we will act in a specific situation in the future can be a useful behavioural tool. For example, if we commit to increase our equity exposure or invest more if markets fall by 30% it both helps to re-frame how we might feel in such situations and also decrease the risk of poor decisions. When markets fall by 30%, are we going to follow through? Probably not (for all the reasons already discussed) but the fact that we have stated that we had planned to, might just help us avoid doing the exact opposite.
—
The behaviour gap is driven by the divide between investment theory and practice. Investment theory is scientific and clinical, which is great but has one slight flaw – it leaves out the influence of emotion and psychology – and that is the whole ball game! Investment theory ignores the lived experience of investing.
How do we deal with the behaviour gap? We don’t need to strive to make perfect investment choices, and we don’t need to optimise for anything. What we need to do is avoid making big mistakes – that’s the gap that really matters – and that is easier said than done.
Joe’s first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray and shows how we can make better decisions. You can get a copy here (UK) or here (US).
This article was originally published by Behavioural Investment.
