How the Behavior Gap Affects Your Investments
Next week marks two years from the passage of the CARES Act and the start of economic stimulus measures that helped the U.S. economy recover from the first wave of pandemic shutdowns, faster than many expected. And thanks to additional stimulus measures, along with the onset of vaccines and treatments, the U.S. stock market continued rising to new highs from those early pandemic days into late-January, when anticipation of the Federal Reserve’s plan to raise interest rates started agitating markets.
The U.S. stock market has been hovering in correction territory (a decline of 10% or more from a recent high) since late-January and has largely stayed in that range since Russia invaded Ukraine (the external variable) at the end of February. As if perfectly timed with the stimulus’ 2-year anniversary mark, on Wednesday the Federal Reserve announced a quarter-percentage-point rate hike, officially marking the end of Covid-19 stimulus measures.
The broad stock market indexes largely took the interest rate news positively. As of this writing, the S&P 500 saw three consecutive days of gains and is on track to gain 5% this week. The Federal Reserve announcement and positive stock market response is certainly a welcome milestone in the path to post-pandemic life, however, the war in Ukraine remains in the news headlines, and in the hearts and minds of many around the globe.
As we have written in previous newsletters, market corrections are a normal and inevitable part of investing. Moreover, history of similar geopolitical events tells us that the impact on economies and markets will likely be modest. Yet, we recognize these events can be unsettling to even the most seasoned goal-focused, plan-driven, long-term successful investor.
In light of these times, we thought it would be helpful to share the work of Carl Richards, author of The Behavior Gap, who writes, “It turns out my job was not to find great investments, but to help create great investors.” From increasing our budget mindfulness to taking a steadier approach to investing, Richards has drawn attention to the way our unexamined behaviors and emotions can be to our detriment when it comes to living a happy and financially sound life.
The Behavior Gap Explained
Coined by Richards, “the behavior gap” refers to the difference between a smart financial decision versus what we actually decide to do. Many people miss out on higher returns because of emotionally driven decisions, creating a gap — “the behavior gap” — between their lower returns and what they could have earned.
Richards’ writing often highlights how, in many cases, we make poor financial decisions when experiencing panic or anxiety as a result of personal or widespread events. Below are a few of the most common financial behaviors driven by such events.
Four Common Emotions Related to the Behavior Gap
1. Excitement When Stocks Are High
Whether in a rising market or witnessing the hype from an IPO, many investors may feel tempted to increase their risks or attempt to gain from emerging investments when stocks are high. This can lead to investors constantly readjusting their portfolios as the market itself experiences upswings. An investor who follows such patterns is likely to do the same with declines and may end up trying to time the market amidst its inevitable, unpredictable movement.
2. Fear When Stocks Are Low
In response to market volatility, investors may feel the need to choose more secure investments and avoid uncertain or seemingly unsafe investments. When stocks are low, a common response may be to sell, which means one would effectively lock in temporary losses and miss out on potential long-term gains.
3. Engagement in the Search for “Alpha”
People yearn to make money and take action to do so. Throughout our lives, this emotional desire is likely a constant one. As such, many seek the help of a financial advisor to procure above-average returns, otherwise known as “alpha.” However, in this search for “alpha,” our humanness — our emotions and our behaviors — may lead us astray. Ironically, studies done by DALBAR have calculated the “average investment return” as compared to average investor returns and have shown that average investor returns are lower. The underlying emotional desire and pursuit of money is exactly the recipe for unwise behaviors in response to emotions — but only if left unchecked.
4. Short-Term Anxiety and Focus
As humans, viewing aspects of our lives through the lens of current circumstances is normal. One emotional response to any event, however, is letting the moment consume us. In such times, many find it difficult to both think long-term and to remember logic. However, making a rash decision can inhibit the long-term benefit that comes from maintaining a balanced perspective without reactionary behavior.
How to Lessen the Behavior Gap for Your Financial Health
As stated above, market corrections are normal and expected events along the long and windy road to investment success. At any given point, the market can go up, down or it can remain the same. Remembering the likelihood of recovery over time — and the market’s nearly inevitable up-and-down movement — can provide a more logical angle to calm the nerves.
Charter Oak advisors are continuing to monitor client portfolios as the fluid situation in Ukraine unfolds, and we have been hard at work rebalancing client portfolios and tax-loss harvesting where possible, to offset gains and lower our clients’ tax bills. It is our pleasure and our privilege to serve you and we wish you the best as spring officially begins on Sunday.