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How Lesser Investments Can Create Better Investors

coins in jarOver the 10 years from 2004 through 2013, the S&P 500 returned 7.4 percent per year. An aggregate bond index returned 4.6 percent per year. And yet, the average balanced investor returned 2.6 percent per year. That’s not good.

Year after year, data from Dalbar show that the average investor significantly underperforms the average investment. In other words, the humans that put their money into financial markets have a tendency to underperform their investments—by a wide margin.

On its face, this seems mathematically impossible. The average investor should get a return equal to the average investment. We find this not to be the case. In order to achieve the total return of an investment, you have to buy and hold it over time. This means no buying or selling. Guess what people have a tendency to do at exactly the wrong times? (Note: there is some debate over the Dalbar methodology, but the point remains that people have a tendency to chase returns).

In his book, “The Behavior Gap,” Carl Richards does an amazing job of drawing a simple truth. Many people are self-destructive when it comes to investing, and this leads to their underperformance. He labels this the behavior gap, and provides a plethora of examples of investors buying after the market rises and selling after the market falls. A nice snapshot of his analysis can be found here.

For many years, investment advisors focused on finding the investments that would provide the highest returns. A sea change in the industry now sees many advisors who focus instead on closing the behavior gap — getting an investor return that merely equals the investment return of a passively managed portfolio.

This requires an advisor to focus not only on potential returns, but also on the psychology of clients. What good is an extraordinary investment return if you can’t get the investor to stay in at the right times?

Selecting investments that fluctuate less over time —  investments that induce less panic and euphoria — may help close the behavior gap. In other words, by selecting assets with lower returns, there may actually be a way to improve investor performance. By appropriately selecting assets that fit the risk profile and psychology of an investor, the advisor has done a service of creating a portfolio that the investor can tolerate through peaks and troughs.

What’s worse? Holding a portfolio of all bonds with an expected return of only a few percent, or holding a portfolio with stocks that causes the investor to sell directly after a market drop, buy back after it rises, and ultimately leads to negative performance?

This is why an asset like gold is right for some people. It is highly volatile and provides little return historically. But there is evidence that gold provides strong returns relative to other asset classes during financial crises. Some investors are drawn to the metal, perhaps because of its reputation as a form of “insurance.” If holding a share of your portfolio in gold provides comfort and allows you to remain calm during market turbulence, then it could lead to much better long-term performance, regardless of what the price of gold itself does.

Personally, I struggle to understand why people I know are invested so conservatively, even when age and other factors are taken into consideration. I prefer a great deal of risk in my portfolio. What I’ve come to realize is that many people are risk averse. Annual fluctuations in their portfolios cause stress and anxiety. Carl Richards has helped me to realize that every individual should endeavor to hold a portfolio that allows them to close the behavior gap. That may mean holding assets that provide lower — but less volatile — investment returns instead of higher ones.

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