- Posted by Fred Kneib, AIF
- On July 23, 2018
- advisor, financial plan, financial planning, investor behavior, planning
A recent study by Dalbar showed that during the 20-year period ending in 2017, the S&P 500 index averaged a 7.20% annual return while the average equity fund investor captured 5.29% over the same time period1. In the investment world, this 1.91% difference between investment returns and investor returns is called the “behavior gap.” Understandably, this gap can significantly impact your long-term financial trajectory.
MARKET HEADLINES AND INVESTOR BEHAVIOR
While many factors hold back individual investor performance, the most significant issues occur when investors mistake market headlines for recommendations to buy, hold, or sell investments. Worse yet is when market headlines derail or even replace a comprehensive financial plan. The process typically goes like this:
1. A dramatic market headline comes out
2. Investors feel the emotional response of fear or greed
3. These powerful emotions trigger irrational investor behavior
To help you avoid this process, and the negative investment performance that often comes with it, we wanted to share two common irrational behaviors we see which are triggered by market headlines.
Confirmation bias happens when investors seek out, or place more weight in, headlines and articles which support their own opinion. Investors who struggle with confirmation bias may also ignore information, data, and research which provide a contrary outlook on an individual stock, investment strategy, or entire sector of the market. While acting on confirmation bias is common, it is also relatively simple to defend against. Reading articles which provide differing opinions or working with a financial advisor who can vet your beliefs and help you invest objectively are two great starting points.
Herd mentality is a condition causing people to feel the need to adopt the behavior of their peers. This phenomenon helped spur “Tulipomania” in Holland during the 1600s – when the price of a single tulip bulb exceeded the cost of some homes – and was undoubtedly a factor in the dramatic rise and fall of Bitcoin prices in 2017 to 2018. Herd mentality is nothing new, but the prevalence of investment-related news on the television and social media has made it easier than ever to feel the need to follow the decisions of friends, family members, and coworkers.
AVOID FOLLOWING HEADLINES WITH A FINANCIAL PLAN
The best way to eliminate irrational investment behavior is to develop, and follow, a financial plan. A comprehensive financial plan will address which investments you should be holding based on your specific situation, explain why you are holding them, and what your time horizon is for the investments within your portfolio. When combined, these three aspects of a financial plan help investors ignore the noise that comes from newspaper headlines, social media posts, or the cable news pundits.
At RAA, we help protect our clients by building a financial plan that keeps them on the path to their specific goals. If you’d like help developing a comprehensive plan of your own, request a custom financial consultation to get started.
1 Information obtained from Dalbar’s “2018 Quantitative Analysis of Investor Behavior Report.” Dalbar Inc. is an independent third party and is not associated with RAA.