Investors often behave in ways that run counter to their own interests. Carl Richards, a financial planner, a blogger for The New York Times, and a contributor to MorningstarAdvisor.com has written a new book that addresses this tendency and it's called The Behavior Gap.
Morningstar's Director of Personal Finance Christine Benz spoke with Richards to discuss concepts he's written about in his book.
So your book, The Behavior Gap features a number of sketches, most of which originally appeared in The New York Times and you use them as kind of a framework for teaching some of these broader concepts about investment mistakes that people often run into.
Let's start with the one that is on the front cover of the book. This is the one that looks at the difference between fear and greed and how investors often shoot themselves in the foot by making inopportunely timed purchases and sales.
This is one of those things that we often, when it comes to money, we make it way more complicated than it needs to be. Investing success is pretty simple.
We all learned, probably when we were pretty young, you buy some investment low, and you will hope to sell it at a higher price later.
But what we often see, because of this hard-wired issue we have with fear and with greed, is we see people get very, very excited, and that turns into sort of greed after an investment has done really well, and one of the best examples of that is late '99--and still easy to pick on--the tech bubble.
As an example, right after we had this huge run in '97, '98, '99, you saw massive inflows into equity funds, and specifically large-cap and technology funds in the United States, in January, February, and March of 2000.
In fact, we shattered all previous records. But what's so fascinating about it is that it was right after a huge run, not before, but right after.
So ... this is kind of a genetic, almost a genetic, issue. We want more of those things that are giving us pleasure or satisfaction or security, and we want less of those things that are giving us pain.
So we tend to pile in at the top, and we're notorious for it, and then we bail out at the bottom, and it's the only thing that we purchase that way. We want to buy more when it's marked up, and we want to get rid of it when it's on sale. So that's what that sketch was about.
So one thing you mention in the book is knowing yourself and knowing your own tendencies toward fear and greed can help you manage around those issues. Let's talk about what you mean by that?
I think that one of the great things about investing is that we have records. We have proof of our own behavior. Now, it's often very painful to face, but this is a suggestion--this is a great thing to do.
Go back and look; you've got your brokerage statements. You've got your tax returns from the last 10 years if you've been investing that long: go look.
Did you find yourself wanting to buy dotcom stocks in '99, like I did? Did you find yourself selling and going to fixed income and to bonds in 2002? Did you find yourself wanting to become a real estate investor in 2006 and '07, only to bail out of everything in '08.
And I think if you go back and look, you can get a feel for, that was how I really behaved. And if you find, and a lot of people are this way, if you find that fear was what caused you to make the most mistakes ... I think we get in trouble when we're trying to have both.
We want full participation in up markets, and we want protection in down markets--like somebody is going to ring the bell for us when things are about to turn.
I think if you start to understand [that] fear plays a huge role in my life--and I'm speaking personally--I don't like, and most of us are this way, we don't like [losses].
The pain of loss as much greater than the reward of gain. I don't like losing money at all.
And so now that in 12 years, I've gotten three major lessons of that, it's finally gotten through my head that I should position my portfolio permanently to protect me against loss, and that needs to be a permanent decision.
Now with the trick, Christine, is to remember that the next time things are going crazy for a number of years, and everything is good, and ... Brian Williams is on TV telling us it's time to buy again, I can't get caught up in that, because I made a permanent decision to position my portfolio to protect me from loss and pain, because I don't want to live through that.
So you're not saying you're all-cash with your portfolio, just saying that your portfolio skews toward providing some downside protection?
That's exactly right. ... Maybe somebody my age with my same set of goals would be [40% or 50%] fixed income, I may be more like [60% or 70%] because I've recognized that bias in myself.
And again we'll see when we have another raging bull market if I can stick to it, but that's what my investment policy statement is there for--to help me to stick to it.
But I need to realize that you can't have it both ways. So protecting myself, making a permanent decision to position my portfolio towards protecting myself, is something that made sense to me.
So Carl, the title of the book is The Behavior Gap, and you've got a sketch in the book that looks exactly at that, and that is the difference between the investment return and investor return. What are you focusing on there?
It used to be that this was a hard concept for people to understand, and now Morningstar in the US is providing that under their return metrics or performance metrics page of each mutual fund.
Years and years ago, there was a study done by a research firm called DALBAR. It has since been repeated by Morningstar with a different degree of results, but they all say the same thing, and that is, often we get confused between the return that investments earn, and the return that an Investor actually gets.
So let me give you an example; let's say you have a mutual fund that has a 10-year return, and I am just going to pick a number to make the math easy, 10%.
Now that's the return that you would have gotten if you had put money in on day one, 10 years ago, and left it there for 10 years. You didn't add any money, you didn't take any money out. You didn't switch to the next hot mutual or the next hot mutual fund and make all these [trades]. You just put the money in and you left it there.
Well, we can then go look and see what the average investor in that exact fund, essentially, what their return was over that same time period, and ... at least all the studies I have seen, show that ... in most cases, the return that the actual investors earned was lower.
Of course there are expenses in there, and there are some other things, but most of that, at least my experience, and I am not an academic, but my experience has been, most of that is due to poor behavior.
We are notorious for, again, selling, getting out of this fund, buying a fund that made some list of 10 hot funds you should own now, only to sell it a couple of months later when it doesn't perform up to your expectations.
So that was the original behavior gap. Label that difference there between investment return and investor return, the behavior gap.
It has grown to mean, at least to me and what the book was about, was about any behavior that got in our way of positive financial results.
The fascinating thing is that this behavior gap, in terms of magnitude, can really swamp a lot of the things that we investors focus on.
So whether it's expense ratios, which are very important, or picking one large-cap fund versus another, these behavior gaps can be way more impactful, but people don't talk about them or think about them quite as much.
For sure. The epiphany for me earlier on in my career, probably like nine or 10 years ago was, "Wait a second--I could own a mediocre investment, and if I just behave correctly, I'll outperform 99% of my neighbors." I am making those numbers up, but the issue is that it's really, really important.
And I remember seeing a Consumer Reports issue on mutual fund fees, and the whole thing was about how to save a quarter of a percent here or there on fees, which is really important. But there was one sentence in there that referenced either Morningstar's version of the study or DALBAR's version of the study that said, after you found your inexpensive mutual fund, realize that poor behavior could cause you to lose 1%, 2%, 3%. But it was one sentence out of a three-page report on how to save a quarter of a point on fees.
So I think, at least the way for me to view it is, we want to eke out every single thing we can in terms of saving on fees and taxes and making wise decisions. But once we do, we have got to behave correctly, or we are going to waste all that.
There has been a lot of academic research around this topic of investors who are overconfident and how that can impede their investment results. Let's talk about a sketch that you've got in the book on that front and also the experiences that you've had with investors who are overconfident.
I think overconfidence, besides fear and greed, it seems to be the little third partner of this little group that's always lurking around big mistakes. I think it's so tricky, because overconfidence is exactly how you would expect an expert to behave.
So where you cross that line between confident and self-assured, and overconfidence is really, really fuzzy.
It's a problem of experts, and so whenever you are taking care of your own money, or if you are offering advice to other people on their money, you've got to consider yourself at least somewhat confident or else you wouldn't be making those decisions.
The key is to figure out when we cross the line from confident to overconfident. It's really challenging. As I say in the book, if you are not worried about overconfidence, it's probably because you are overconfident.
So I think we just need to be more humble about the decisions we make when it comes to investments, and realize that often our gut is wrong on the investment side. Often it would make sense to run ideas past two or three people.
The other tricky thing about overconfidence that's really a whammy is that if you have a plan that you are very confident in, and you hold on and hold on and hold on, and then you finally capitulate, you are the one that's going to suffer the most.
Because the people who bailed out early, they didn't suffer nearly as much as you did by being confident in your plan. So there is this really fine line--confident in your plan stick with it.
So the big risk of being overconfident in your view is that you can position your portfolio to benefit from one outcome but not really position it for outcomes that you didn't anticipate.
That's really good point. I think we are notorious for not understanding ... we are very bad in understanding things we don't know. I think often you position ... you think you've got one outcome.
We need to pick an individual stock, or even an industry--let's say I really feel strongly that commodities are going to do well next year. The fear with overconfidence is that you position a portfolio in a way that if you are wrong, you are going to really suffer.
There is a conversation I like to have called the ‘overconfidence conversation' where you just give yourself permission to consider what would the impact be if I am right, and what conversely, and be careful, what would the impact be if I am wrong about this decision? How would my life change?
So the idea is that you don't want to position your portfolio to benefit from all-or-nothing outcomes. You really want to think about what's the devil's advocate case for this thing that I think I am so sure about.
There can be reasons we'd want to roll the dice on an all-or-nothing outcome. But you certainly wouldn't want to do that without at least recognizing that's what you are doing.
So Carl, you've got a great sketch, it's not in the book, but I think it's a really important one. It's about how investors often proceed straight to security selection, so they start picking stocks and funds or whatever, without having a plan. Why do you think it's so important to have a plan before you begin selecting investments?
I think it gets down to this idea that, I am far more interested in asking the right questions than I am in coming up with the right answer.
You know the old Stephen Covey phrase, it's terrible to spend life climbing a ladder, only to find out when you get to the top that it's leaning against the wrong wall.
And I think that happens a lot in investing, and particularly because we've got a whole industry and kind of a media complex built around the idea that investing is about one thing. And we have been trained to think this: that our well-intentioned goal is to scour the planet for the best investment.
The problem is, there isn't really such a thing as the best investment. It depends on your situation. Like it's said, personal finance is more personal than it is finance.
And so, I get asked all the time, "Is Apple a good investment?" I don't know. "Is XYZ mutual fund good?" Or "What do you think of the market, is now a good time to get in?" I have no idea. It depends on your plan.
... And it has corollaries in other industries. You would never walk into the doctor's office with an ailment--sometimes we feel like this happens--but you would never want to walk in or we all hate it when we walk in, and we don't feel like the doctor took time to diagnose, and we just walk out with the prescription, and we're not even sure it's right.
So prescribing without diagnosing would be malpractice, and I think we have that same problem in the investment world. Often we're so focused on the product, the investment, we need to back up and say, All right, what are we doing? What's the plan? What is our--and don't get scared with this term--what is our "financial plan"? And then we define what investment process, not specific investment, but what investment process will get us there, has the highest likelihood of getting us there. Then we'll figure out which investments to actually use to populate the plan.
Another corollary, often I think people are arguing about whether to take a plane, train or a car, before they have even figured out where they're going.
I was talking to a planner recently, and she said one problem she often encounters is that people come in with very well-crafted portfolios. They've taken a lot of care in selecting these investments. But they just are not going to have enough money, given their current savings rate. So they have focused on one piece of it, but really neglected taking that step back that you're talking about and saying, "OK, are these investments, and the amount of these investments, on track to get me where I need to go?"
That's so important. We've been trained and conditioned to think that rate of return is the only variable that matters. When in reality, there is a whole bunch of levers.
And the other thing that's really important, and I also think sort of refreshing, is that some of the other levers, we have more control over. We have more control over our expectations and goals. We ... certainly have more control over how much we save than we do on market rates of return.
You may be saving as much as you possibly can, but there is more control over what are your goals, how much are you saving, when are you going to retire? Those sorts of things are the other levers ... And how much you save has such a huge impact relative to the investment rate of return.
Look, if you're going to earn 7.5% versus 8.5%, that's such a minute difference. I mean, sure, compounding is going to make it into a bigger difference, but it's so much smaller than if you just saved an extra $100 a month.
In a way, it's sort of empowering to say, "Well these are things I really control. I don't control what my portfolio returns, but these are the things that are within my sphere of influence."
The most popular sketch I've done is this circle sketch that in one circle, it says, "things you can control," and in the other circle it says "things that matter," and the overlap is labeled "what you should focus on."
I think that you're right--that is empowering. And I have chosen in on my own life--and this is just for me--and again I'm not recommending this for anybody, but I've chosen to downplay the things I can't control, like rate of return.
We talked about this earlier. Out of fear and the fact that I have no control, I'd rather underemphasize that, and I'd rather focus on trying to figure how to save a little bit more, or adjust my goals to be more realistic, because ... it makes me feel like I'm in more control.
The article first appeared on Morningstar.com and has been formatted for India.