Exploring The Behavior Gap
Recently, the Truepoint book club read The Behavior Gap: Simple Ways to Stop Doing Dumb Things with Money, by Carl Richards. In it, Richards coined the term “behavior gap” to explain the gap between investor returns and investment returns. What this means is that, in general, returns that investors have earned over time are much lower than the returns of the average investment.
Why does this occur? The short answer is that our biology gets in the way. We are wired to seek safety when afraid and pleasure when unafraid. Our natural reaction is to sell equities when the markets are falling and buy equities when the markets are rising. In doing so, we “indulge our fear and our greed.” So, how does this affect investment returns? Simply put, our wiring leads us to sell low and buy high – exactly the opposite of what one should do. The obvious result is underperformance.
This concept is not new for Truepoint clients. Our passive investment philosophy and ongoing rebalancing process was designed to remove greed and fear from the portfolio management process. Our clients have been rewarded by our disciplined investment management process as our results continue to outperform the broad markets.
This book is not just an in-depth discussion of investor behavior, however. The majority of the book is devoted to our challenges with the financial planning process. After all, planning for the future involves much more than portfolio management.
Richards stresses that personal financial planning is more personal than financial. The advice provided to you may be vastly different than the advice provided to your neighbor who may work at the same company, earn the same salary and have an identical net worth as you. This is because a good financial plan will be unique to your goals, objectives and values. It will guide you in making good money decisions that are aligned with those goals, objectives and values.
Sounds easy. So, what’s the problem? Well, planning for your future involves a lot of trade-offs that create tension between living for today and saving for the future. Let’s face it, it is more fun to spend $5,000 on a cruise this January than it is to deposit $5,000 into your IRA to eventually fund items such as that very cruise, albeit at a much later date.
According to Richards, your participation in the financial planning process is really just a balancing act between living in the present and planning to live in the future. A financial plan will identify those actions that increase the likelihood of achieving your financial goals, while providing you with the framework needed to make good money decisions. As Richards states, “sensible, reality-based choices are our best shot at reaching our goals.” Stated another way, the plan will identify where you are today, where you want to be later and how you need to behave to get there.
The key to your success is captured in five words in the preceding sentence – how you need to behave. It comes down to focusing on what you can control – your behavior – whether it is related to how much you spend, how much you save or how you react to volatile stock markets. Ultimately, it is your behavior that has the most significant impact on whether or not you will achieve your financial goals.
This is where the benefit of having your Truepoint advisor at your side is most clear. Not only is our investment management process designed to control behavior, but our financial planning process keeps you focused on executing those steps that increase the chance of your financial success regardless of economic uncertainty, global terrorism, rising sea levels or <insert your own uncontrollable concern here>. As Richards states, “What matters is what we did or didn’t do in order to move closer to our goals.”