January 2010
The Behavior Gap
For the 20 year period from 1989 through 2008, the S&P 500 index had an average annual return of 8.42%. However, the average stock mutual fund investor earned only 1.87%. [The Dalbar Study, 2009] Say you invested $10,000 at the beginning of 1989 and left it in the S&P 500 index until the end of 2008. You would now have $50,370 in your account. But your friend, Average Investor, had only $14,490 in his account at the end of those 20 years, almost $36,000 less than you. Now multiply that number by 10 times or more.
What explains this incredibly large difference? One financial advisor, Carl Richards, has named this "The Behavior Gap." The problem is, investors can’t help but be human. And humans are largely driven by their emotions when it comes to investing. We are genetically encoded to pursue more of the things that give us pleasure and to get away from things that cause us pain. At the top of a bull market, money flows in; during and after a bear market drop, money flows out.
For example, in 2008 alone $234 billion flowed out of equity mutual funds. This was ten times the previous record. Some economists have pointed out that we may never know how much of the market downturn was caused by the credit crunch and how much of it was due to investor panic. Investors across 25 developed nations, including the U.S., had $10.4 trillion of their wealth in stocks at the end of the second quarter of 2008. A year later, at the end of the second quarter of 2009 (while the market rally was already underway), that stock exposure had fallen nearly in half, to $5.9 trillion. In the U.S., much of that money went into Treasuries — just in time to catch a rare losing year in government bonds.
The same thing happened during the market cycle of 2000-2002. After an 86% runup in the markets, in the first three months of 2000, $140 billion came into equity funds. Their timing was impeccable: we now know that the market peak was March 24, 2000. Less than three years later, by October 2002, the market had dropped 50%. Now instead of buying equities at the best "sale" prices in five years, record amounts were pouring out of the funds for five months in a row. It was a classic "buy high, sell low."
We are wired to stop the pain we experience from losses, because the part of our brain that processes risk is the amygdala. As explained by Jason Zweig in Your Money and Your Brain: "The amygdala helps focus your attention, in a flash, on anything that’s new, out of place, changing fast, or just plain scary. ... After all, in the presence of danger, he who hesitates is lost; a fraction of a second can make the difference between life and death … This same fear reaction is triggered by losing money – or believing that you might. ... However, when a potential threat is financial instead of physical, reflexive fear will put you in danger more often than it will get you out of it. Selling your investments every time they take a sudden drop will…make you poor and jittery." (pgs. 160-161)
It is the investors who listen to and respond to that part of the brain who will trade too much, buy and sell at the wrong times, and give up almost 80% of the market’s return – and dwell in The Behavior Gap. Ultimately, investment success isn’t about skill, it’s about behavior.
At Silver Oak, we believe there are two components to investment management: managing the client (and their behavior), and managing the portfolio. One of our main responsibilities is to help clients close The Behavior Gap to something close to zero, by keeping them invested in downturns as well as upturns. We’re not saying it’s easy. Since 1950, the average daily market movement for the S&P 500 has been 0.97% in either direction. In the final quarter of 2008, that figure rose to 4.22% per day – an unprecedented number, what economist David Kelly called "a 100-year flood of volatility." During the first five months of 2009, the average daily volatility was 2.63% a day, still way above the longer term average. And even though the market settled in the last half of 2009, the average daily movement was nearly double the historical average.
Controlling your behavior is challenging under the best of circumstances; doing it during stressful times may seem impossible. Re-balancing a portfolio in declining markets asks you to take action that may feel like "throwing good money after bad" – and it needs to be done anyway. You need someone who cares about your money as much as you do, and has the emotional distance to help make prudent decisions. We are here to do that, to coach you, to educate you, because we are serious about wanting you to reach your goals. We are happy our clients came through this last bear market without the level of significant losses others experienced, and we know that it’s not the last bear market we will experience in our lifetimes.
We hope that the next decade will bring calmer markets, a recovered and improved economy, and saner investment choices by the public at large ("save more, spend less" and "don’t buy a house you can’t afford" immediately come to mind). In closing, we quote journalist Bob Veres, who wrote recently: "We don’t know what the future will bring, but it’s a good guess that the trauma of 2008, and the first decade of the millennium, will be remembered as unusual detours in the longer-term upward march of the markets."
Upcoming Workshops
The next "Investment Boot Camp" programs will be held:Saturday, January 30, 9:30 to 11:30 am
Seating is limited; please RSVP to Linda at (503) 242-1715 or register on our website.