The behavior gap represents the difference between investment returns and the returns actually realized by the investors. It stems from the propensity of investors to embrace their natural (and flawed) behavior resulting in poorly timed investments.
While Warren Buffet famously advised to “be fearful when others are greedy and greedy when others are fearful,” academic evidence suggests that his guidance has been widely ignored. The performance-chasing phenomenon is well documented, with one of the more recognized works being the appropriately named Carl Richards book The Behavior Gap: Simple Ways to Stop Doing Dumb Things with Money. In his work, Richards (who is also credited with coining the phrase ‘behavior gap’) discusses some of the systematic and psychological reasons why investors consistently underperform their investments. His conclusion? Investors are their own worst enemies.
“It’s not that we’re dumb. We’re wired to avoid pain and pursue pleasure and security. It feels right to sell when everyone around us is scared and buy when everyone feels great. It may feel right-but it’s not rational.” -Carl Richards
We’ve seen this irrational behavior first-hand in the managed futures industry. According to data from Barclayhedge, the best 2-year performances for managed futures (as represented by the Barclay CTA index) in the past 15 years were in 2002-2003 and 2007-2008. Over that same timeframe, the largest 2-year asset inflows were in 2003-2004 and 2010-2011. On the other side of the coin, in the last 15 years the worst performance for CTA’s occurred from 2011-2013 while the largest asset outflow (by a wide margin) occurred in 2014.
[drizzle]While we’ve touched previously on the danger an investor’s own psyche can present to his investment portfolio, the remarkable persistence of this particular cognitive bias merits further investigation. Not only is the behavior gap incredibly prolific, the extent with which it can erode an investor’s performance is unnerving.
Betterment.com took a comparative look at several studies and found that our inherent cognitive biases could be costing equity investors between 1.2% and 4.3% annually. For more active investors, this loss can increase to 6.5% a year.
These numbers represent the annual return below the S&P 500 benchmark of 8%, so for an investor to miss by 6.5% indicates that while the S&P 500 might average 8% a year, he is only realizing a profit of 1.5% (and losing over 80% of his potential profits to the behavior gap).
Unfortunately, there doesn't seem to be much evidence suggesting a shift in behavior as marketing firms take center stage and headlines rule the day. Today's investor faces a financial ladscape abounding with slings and arrows, but perhaps the biggest danger to his performance is looking at him in the mirror.
PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS
About Covenant Capital Management
“Covenant Capital Management is a boutique CTA that has been managing client assets for over 15 years. CCM has offices in Nashville and Chicago, and employs a systematic trading methodology across global futures markets. The goal of Covenant Capital Management is to provide clients with the highest risk-adjusted returns available in the market. You can reach CCM at their website www.covenantcap.com or on twitter @covenantcap.”
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