Why investments outperform their investors
Joel Dresang: Kyle, let’s talk about the behavior gap. That’s a term that academics use to help explain why investments do better than investors. Help us understand that.
Kyle Tetting: Ultimately Joel, what we find is that investors tend to underperform the investments they invest in. And specifically when you look at mutual funds, you have these measurements of investor return and investment return, and what really describes that difference is a behavior gap – that investors just aren’t behaving the way they should be behaving with investments.
Joel: What does it come down to, market timing?
Kyle: Yes. You know, ultimately, that really is what it is. It’s that investors tend to do a very poor job with volatile investments. That the more peaks and valleys there are in an investment, the more opportunity there is to try and time, the more opportunity there is to get things wrong.
And what we see is that they get two things wrong. One is they tend to sell when things are getting really bad, when markets have tended to get near their bottom – the absolutely wrong time to sell. The other is that as things tend to peak, as markets really are rallying towards the end of a cycle, they tend to be buying more of those volatile investments. And, as we know, that’s really the reverse of what you’d like an investor to do, which is to buy low and sell high.
Joel: So they’re giving in to those emotions of fear and greed.
Kyle: Absolutely. And again, it’s the volatile investments that create more opportunities to give in to fear and greed. You know, the more something bounces around, the more peaks and valleys there are going to be, the more opportunities an investor has to make the wrong decision about what to do.
Joel: So what can investors do about that? How can they narrow that gap?
Kyle: The biggest piece for that volatile investment, whether it be stock investments or something else that bounces around a lot, is just to have a thesis for that investment. Really understand why it is you’re buying it. And ultimately, every time you want to make a decision about buying or selling that fund, buying or selling that investment, remember what that thesis is, and really focus on why it is you’re holding what you’re holding.
Joel: So it’s a matter of trust.
Kyle: It absolutely is a matter of trust. You know, again, it’s why am I holding this? Because ultimately that’s what’s going to drive the investment decision. It shouldn’t be the fear and greed that drives the investment decision.
Joel: So what about less volatile investments like fixed-income, bond investments?
Kyle: Joel, I think that’s the important piece is that the less volatile investments investors have done a much better job of sticking with. I think they understand the role that bonds play in their portfolio, and that is that it keeps a portion of your money in safer areas of the market.
The challenge, of course, is that you’ve got to understand what your overall balance is. You’ve to properly build a diversified portfolio because it’s that safe stuff that lets you take risk with some of more volatile stuff.
Joel: And when we talk about market timing, we know that that doesn’t make that big of a difference in the success of an investor.
Kyle: Yes, Joel. Ultimately, it’s the asset allocation that’s the biggest piece of the likelihood of investor success. And so, when we’re looking at this behavior gap, when we’re looking at the difference between investor return and investment return, it’s the asset allocation piece that can help – properly done – that can help to overcome that behavior gap.
Kyle Tetting is director of research and an investment advisor at Landaas & Company.
Joel Dresang is vice president-communications at Landaas & Company.
Money Talk Video by Peter May and Jason Scuglik
The ups and downs of volatility, a Money Talk Video with Steve Giles
7 tips for successful investing, a Money Talk Video with Marc Amateis
The Importance of Balance for Investors, a Money Talk Video
What investors need to know about volatility, from the Financial Industry Regulatory Authority
Your one-minute guide to stock volatility, from the Financial Industry Regulatory Authority
(initially posted August 30, 2017)