A study in their investment pattern shows that Mutual Fund investors generally increase inflows after observing periods of strong performance. They buy at high prices when future expected returns are lower, and they sell after observing periods of poor performance when future expected returns are now higher.
This results in what author Carl Richards called the “Behavior Gap,” in which investor returns are well below the returns of the funds in which they invest.
Perhaps with this observation in mind, Warren Buffett once remarked, “The most important quality for an investor is temperament, not intellect.”
In his wonderful book “The Behavior Gap,” Richards recommends asking three questions before you make investment decisions based on your own or someone else’s forecast:
1. If I make this change and I am right, what impact will it have on my life?
2. What impact will it have if I am wrong?
3. Have I been wrong before?
Asking and honestly answering those questions should have you acting more like Buffett (who recommends against trying to time the market, but tells those who do it to buy when others are panicked sellers) and less like the majority of investors who are engaging in behavior, destructive to their portfolios.
When Carl talks about the behavior gap what he is referring to is the difference between Investment returns and Investor returns. The difference between these two is where our actions, behaviour and emotions come into play.
In fact, according to Vanguard founder John Bogle, the average equity mutual fund investment gained 173% from 1997 to 2011, but the average equity mutual fund investor earned only 110%. This is because we let our emotions control our investment decisions. This is our Behavior Gap.
Few lessons mentioned below would be helpful for anyone who wishes to deal with this 'Behaviour Aspect' in case of making Investment.
Lesson 1: Be honest with yourself.
We must be able to admit which emotion we succumb to more often, fear or greed. If you are nervous anytime the stock market corrects, it’s fear. If you can’t stand to sit out of a rising market and you are an aggressive investor, it’s greed. Make sure you know which one affects you more and develop an investment plan accordingly because using them both can cause you to sell at the bottom when you are scared and buy at the top when you are greedy.You also need to understand that there are countless unknowns in the markets and economies you invest in. Knowing that factors are out of your control will help you make corrections to your process and adapt when your circumstances change.
We also must admit that there is no perfect investment out there. Coming to this realization can relieve a lot of stress from trying to be right all of the time. One of the reasons Money Managers constantly try to beat the market through active investing is the fact that they cannot be honest with themselves
about the alternatives. This is even though countless studies show that over the long-term the majority of active managers don’t beat simple index funds.
Lesson 2: The beauty of simplicity.
We’ve all heard the phrase that less is more. But no one likes to use the simple choice. We assume that the complex investment strategy will work over the simple one because the really smart investment managers must have a good reason for charging such high fees for their investment ideas. Try not to over-think your finances. Simple is better for your long-term results and much easier to understand.
Here are some great lines from the book about keeping things simple:
“Being slow and steady means you’re willing to exchange the opportunity of making a killing for the assurance of never getting killed.”
“Slow and steady capital is short-term boring. But it’s long-term exciting.”
“We often resist simple solutions because they require us to change our behavior.”
Most people look for the complex investments or solutions to their problems because it is easier than making meaningful behavioral choices. That’s why there are new fad diets and infomercial exercise equipment every year that offer to solve our health problems without mentioning that eating right and consistent exercise is the simple way to go about losing weight.
Lesson 3: Happiness is the key emotion.
We often talk about fear and greed being the investor’s two biggest enemies when investing. They cause you to buy high and sell low. But how do you combat these two irrational decision-makers? After reading this book it would seem to be happiness.
The book discusses a study that shows that having a good family life leads to more personal happiness than professional success does. Another study shows that money has a diminishing return on happiness up to around $75,000 a year in salary. So while money can buy some happiness, it only does so up to a certain point.
Carl goes on to discuss how most financial decisions are really just life decisions. Thinking in those terms could really change the way you view your money and your life. It helps to decide what it is that you really want to accomplish to make you happy by setting goals and focusing on why you would like to achieve them.
Lesson 4: We all make mistakes.
When dealing with complex investments and markets we are bound to make mistakes. Even the best investors do so on a regular basis. One of the most refreshing lessons I have picked up from reading Warren Buffett books and annual shareholder letters over the years is the fact that he admits to his mistakes and doesn’t shy away from them. He tries to learn from them.
Carl admits to some of his biggest financial mistakes in this book. He talks about having the discipline of staying out of technology stocks in the late- 1990s tech bubble right up until 1999 when he finally capitulated. The stock he bought shot up immediately but within months came back down to Earth and he
suffered a large loss. But he learned from the experience and uses it as a teaching point to this day.
Don’t trust advisors that never admit their mistakes and are always blaming others either. It’s not investments that make mistakes but investors. It feels good to take credit for good investments but blame someone else when they go bad. Admit that mistakes happen and move on.
But What About Tactics?
You will eventually need the correct tactics to actually implement your process so I don’t want you to think I am downplaying that part of your investment plan. You need to open the correct accounts, set your asset allocation based on a number of factors, choose funds or securities to invest in and monitor your performance along the way.
But without the correct perspective on your finances and emotions it will be much harder to implement any of those tactics without committing mistakes that the majority of investors make on a regular basis (letting fear and greed take over, making decisions based on those emotions and not having a plan in place to aid in the decision-making process).
The Behavior Gap tells us that financial plans are worthless but the process of financial planning is extremely important. A plan assumes you know what’s going to happen in the future. Which we all know is next to impossible. But consistent planning assumes you admit things will be unpredictable and act accordingly.
A financial crisis can be hard to predict, let alone prevent. Just ask the Federal Reserve. Yet we all spend countless hours worrying about the next economic or stock market meltdown. We don’t spend quite as much time preparing for a personal financial crisis that you have much more control over.
Focus on the slow and steady long-term and avoid making decisions based on short-term emotions. Specific financial advice could be obsolete in a matter of hours, days or weeks while the correct perspective can last you a lifetime.
Here are some other questions you should ask yourself if you believe that you’re best served by being your own advisor.
1. Do I have the temperament and the emotional discipline needed to adhere to a plan in the face of the many crises I will almost certainly face?
2. Am I confident that I have the fortitude to withstand a severe drop in the value of my portfolio without panicking?
3. Will I be able to re-balance back to my target allocations (keeping my head while most others are losing theirs), buying more stocks when the light at the end of the tunnel seems to be a truck coming the other way?
As you consider these questions, think back to how you felt and acted after the events of Sept. 11, 2001, and during the financial crisis that began in 2007.
Experience demonstrates that fear often leads to paralysis, or even worse, panicked selling and the abandonment of well-developed plans. When subjected to the pain of a bear market, even knowledgeable investors fail to do the right thing because they allow emotions to take over, overriding the brain.
P.S - Acknowledge the various websites from where I have collected this Information and represented it.
