What Is the Behavior Gap in Investing?
Make better financial decisions when you avoid the behavior gap.
A gap exists between the rates of return earned when an investor builds a diversified portfolio and the rates of return earned by investors who move their money around in an emotional response to whatever is happening in the markets. A diversified portfolio is balanced and can typically withstand some pretty tough storms, particularly over the long term. Investors who let their emotions take over and who move their money around in knee-jerk responses earn lower returns.
The Behavior Gap
Carl Richards, an author, artist, and financial advisor, coined the term “behavior gap" to describe the difference between the higher returns that investors might potentially earn and the lower returns they actually do earn because of their own behavior. Many investors earn lower returns not because of the investments they choose but because of the way they use those investments. If these investors behaved differently while still using these same investments, they would experience better results.
Artwork and a Book
You can learn how to avoid falling victim to your own behaviors in Carl Richards' fabulous book, The Behavior Gap, Simple Ways to Stop Doing Dumb Things With Money. Richards also offers a plethora of excellent sketches that provide poignant illustrations about our choices. His sketches are found in financial planning offices around the country.
Academic Work on the Behavior Gap
Many forms of financial behavior gaps have been documented by a field of study called behavioral finance or behavioral economics. This field of study began to gain momentum back in 2002 when Daniel Kahneman was awarded the Nobel Memorial Prize in Economics for his work around financial decision-making.
You'll want to learn more about behavioral finance if your goal is to be a good investor. By understanding your behavior and your own subconscious tendencies, you can improve your financial decision-making. A popular book on the subject and a New York Times bestseller, Nudge can offer some insight into how your mind can trick you into making financial decisions that are not to your benefit.
Avoiding the Behavior Gap
You can avoid many financial mistakes by following a disciplined approach to investing and by relying on a logical process to make financial decisions. If you use a consistent analytical approach, it should help you avoid making overtly emotional, reactionary decisions about investing during tough times.
Can a Financial Planner Help You Avoid the Behavior Gap?
Using the services of a financial advisor or financial planner can provide a buffer between your emotions and the financial decisions you commit to. It can also help you avoid the most common mistakes caused by the behavior gap.
Interestingly, there's even a behavior gap around the understanding of what a financial planner actually does, so take some time to learn the differences between financial planning, investment advice, and retirement planning.before you seek services. Each is a distinct service and requires a different type of expertise.
The Most Powerful Tool You Have
You have a powerful tool at your disposal that can help you make better financial decisions: It’s your ability to learn and educate yourself. Don’t waste your hard-earned money by making poor financial decisions. Invest some time in reading reputable financial magazines, newsletters, and books.