What Is the Behavior Gap?
The behavior gap refers to the disparity between the returns that investments generate and the actual returns that investors experience due to their own behavioral decisions. It is a core concept within behavioral finance, highlighting how emotional responses, poor timing, and lack of discipline can erode potential gains. While an investment, such as a mutual fund or an exchange-traded fund, may post a specific annual return, the average investor in that fund often earns significantly less because they frequently buy and sell at inopportune times, influenced by market fluctuations or media narratives. This phenomenon underscores that superior investment returns alone do not guarantee superior investor returns; individual actions play a critical role.
History and Origin
The concept of the behavior gap was popularized by financial planner and author Carl Richards. Through his "Sketch Guy" column in The New York Times and his book, The Behavior Gap: Simple Ways to Stop Doing Dumb Things with Money, Richards used simple drawings and clear explanations to illustrate how investors' actions often undermine their financial well-being. He observed that despite market gains, many individuals underperformed their own investments. This realization stemmed from his work in financial planning and analysis of studies like those conducted by DALBAR, which consistently show a significant shortfall between average fund returns and average investor returns. Richards' work emphasized that the well-intentionintentioned search for the "best" investment often leads to behaviors that cost money.11,10,9,8
Key Takeaways
- The behavior gap measures the difference between what an investment earns and what the average investor in that investment actually earns.
- It is primarily caused by emotional decision-making, such as buying high and selling low in response to market volatility.
- Studies, such as DALBAR's Quantitative Analysis of Investor Behavior (QAIB) report, consistently demonstrate the existence and persistence of this gap over decades.7,6
- Minimizing the behavior gap often involves adopting disciplined, long-term investment strategies and focusing on controllable factors.
- Financial advisors can play a crucial role in helping clients mitigate the behavior gap by providing behavioral coaching.
Interpreting the Behavior Gap
The behavior gap is typically expressed as a percentage point difference between a fund's reported total return and the dollar-weighted (or investor) return. A positive behavior gap indicates that investors, on average, are underperforming the investments themselves. For example, if a fund averages a 10% annual return over a decade, but the average investor in that fund only achieves a 7% annual return, the behavior gap is 3 percentage points. This 3% difference represents the cost of poor investment behavior.
Interpreting the behavior gap involves recognizing that while asset performance is external, the realization of those returns is internal and depends on individual actions. It suggests that consistent application of an investment strategy, rather than reacting to short-term news or market swings, is crucial. High investor turnover, frequently switching between funds or assets, often correlates with a larger behavior gap. This highlights the importance of matching investments to an investor's true risk tolerance to prevent panic selling during downturns or speculative buying during booms.
Hypothetical Example
Consider an investor, Sarah, who invests in a broad-market index fund. Over a five-year period, the index fund generates an average annual return of 8%. This 8% is the fund's published investment return.
- Year 1: Market performs well, fund is up 15%. Sarah, seeing the positive momentum, adds more money to her investment.
- Year 2: Market experiences a correction, fund is down 10%. Sarah gets nervous and withdraws a portion of her investment to limit losses.
- Year 3: Market recovers strongly, fund is up 20%. Sarah, having pulled money out, misses a significant portion of the rebound. She then decides to reinvest some money, hoping to catch the next wave.
- Year 4: Fund posts a modest 5% gain. Sarah holds steady.
- Year 5: Market dips slightly, fund is down 3%. Sarah sells a larger portion of her holdings, fearing a prolonged downturn.
Due to Sarah's reactive buying and selling, her actual dollar-weighted return (investor return) over the five years might only be 3% annually. The 5-percentage-point difference (8% - 3%) represents her personal behavior gap. This scenario illustrates how market timing attempts, driven by emotion, can significantly reduce overall returns, even in a generally rising market.
Practical Applications
Understanding the behavior gap has several practical applications across various facets of finance:
- For Individual Investors: Recognizing the behavior gap empowers investors to focus on what they can control: their own actions. Implementing strategies like dollar-cost averaging can help automate regular investments, reducing the temptation to time the market. Adhering to a well-defined asset allocation and portfolio diversification strategy can provide a framework for stability, even during turbulent periods.
- For Financial Professionals: Advisors leverage the behavior gap concept to emphasize their value beyond simply selecting investments. They act as behavioral coaches, helping clients manage emotional biases and stick to a long-term plan. This involves setting realistic expectations, reinforcing discipline, and providing perspective during market fluctuations.
- For Financial Education Initiatives: The existence of the behavior gap underscores the importance of comprehensive financial literacy programs. These initiatives often focus not just on product knowledge but also on behavioral aspects of decision-making, aiming to equip individuals with the skills to avoid common pitfalls. The Consumer Financial Protection Bureau (CFPB) actively engages in promoting financial literacy to empower consumers and improve their financial well-being.5,4
Limitations and Criticisms
While widely acknowledged, the behavior gap concept and its measurement face certain limitations. Accurately calculating an "average investor return" can be complex, as it requires tracking actual cash flows (contributions and withdrawals) for a large sample of investors, not just published fund performance. Methodologies, such as those used in the DALBAR QAIB report or Morningstar's "Mind the Gap" study, rely on aggregated data, which may not perfectly reflect every individual's experience.3,2
Another limitation is that the behavior gap primarily identifies a problem (the cost of poor behavior) but does not inherently provide a direct solution beyond the general advice to "stay disciplined." While risk management principles can help, overcoming ingrained psychological tendencies is challenging. Critics may also point out that some of the "gap" could be attributed to factors beyond pure emotional investing, such as legitimate changes in personal circumstances (e.g., needing funds for a down payment or retirement) that necessitate withdrawals, which would naturally impact realized returns. However, the consistent underperformance across various market cycles strongly suggests that behavioral factors are a primary driver.
Behavior Gap vs. Timing Risk
The behavior gap is closely related to, but distinct from, timing risk. Timing risk is the danger that an investor's attempt to predict market movements (i.e., when to buy or sell) will result in worse outcomes than a static, buy-and-hold approach. It is the inherent risk involved in engaging in market timing. The behavior gap, on the other hand, is the observed outcome or quantified difference that often results from succumbing to timing risk and other behavioral pitfalls.
In essence, timing risk is the potential for loss due to active trading decisions based on market predictions, while the behavior gap is the measurable consequence of investors repeatedly falling victim to this risk. The behavior gap is a broader concept that encapsulates the negative impact of all investor behaviors that deviate from optimal long-term investing, whereas timing risk specifically refers to the perils of trying to anticipate market highs and lows.
FAQs
Why do investors often experience a behavior gap?
Investors often experience a behavior gap because they let emotions guide their financial decisions. This typically involves buying investments when they are performing well (often at high prices) due to greed or fear of missing out, and selling them when they are performing poorly (at low prices) due to fear or panic. This "buy high, sell low" pattern directly reduces their actual returns compared to the investment's underlying performance.
Is the behavior gap exclusive to individual investors?
While typically discussed in the context of individual investors, the principles behind the behavior gap can apply to any entity, including institutional investors, if their decision-making processes are not robust enough to counter emotional or reactive tendencies. However, studies predominantly focus on the impact on the average retail investor.
How can an investor reduce their personal behavior gap?
To reduce the behavior gap, investors can focus on disciplined strategies such as creating a clear investment plan and sticking to it, regardless of short-term market fluctuations. Implementing automated investing through methods like dollar-cost averaging, maintaining a diversified portfolio, and seeking guidance from a financial advisor who emphasizes behavioral coaching can also be highly effective.
Does the behavior gap mean active management is always better than passive investing?
No. The behavior gap is about investor behavior, not the investment vehicle itself. Both actively managed funds and passive index funds can experience a behavior gap if investors trade them frequently or react emotionally. In fact, some studies suggest that the relative simplicity and lower volatility of broad passive investments may even help some investors stick with them longer, potentially reducing their personal behavior gap.
How significant is the behavior gap typically?
The size of the behavior gap varies depending on the time period, asset class, and study methodology. However, reports like DALBAR's Quantitative Analysis of Investor Behavior (QAIB) have consistently shown that the average investor underperforms market benchmarks by several percentage points annually over long periods, highlighting a significant impact on wealth accumulation.1