The Behavior Gap: Simple Ways to Stop Doing Dumb Things with MoneySubmitted by Dorval & Chorne on May 9th, 2017
By John T. Chorne, CFP® | Tuesday, May 09, 2017
Dorval & Chorne Financial Advisors Quarterly Book Blog
The Behavior Gap: Simple Ways to Stop Doing Dumb Things with Money by Carl Richards
Overview: Carl Richards, a certified financial planner, discusses some of the common mistakes we make when it comes to making money decisions and what to do to correct those mistakes.
I had read The Behavior Gap a few years ago and decided to read it again to use for my second book blog. I have read several other writings by Carl Richards over the years as well. I enjoy his light-hearted writing style, often using illustrations which he fondly calls “back-of-the napkin” drawings. His focus on planning to help reach financial goals also matches our belief in the importance of financial planning. In this book, Carl Richards shares several of his “napkin” drawings to illustrate many of the dumb things we do with money and suggestions on how to avoid or correct those dumb things.
The Behavior Gap concept originated for Carl from studies done by financial and data analysis companies like Dalbar and Morningstar that compare individual investor returns to returns of the markets in general. There is ample evidence that suggests the average investor gets returns significantly below the returns of the markets. We often present some of these results in our seminars. Carl labeled the difference between individual investor returns and the market returns “The Behavior Gap”. It is the first “napkin” drawing shown in the book. Carl goes on to explore the behaviors that cause this gap. It is Carl’s hope that making people aware of these bad behaviors will reduce their occurrences and help close the gap. That is my hope as well. As I often tell people, “Behave your way to wealth!”
What are the behaviors that cause investors to underperform? Here are a few that Carl addresses in his book:
Chasing Returns: We tend to want to buy what has recently gone up and sell what has recently gone down. Simply put, we want to buy high and sell low when it comes to investments. Investments are a unique area where we have this tendency. Would we be excited to purchase a vehicle if we went to a car dealership and the car dealer said to us, “I’ve got great news for you! This vehicle is now priced 20% higher than it was six months ago.”? We probably would not be too thrilled about the idea of paying 20% more for the same vehicle. Yet, this is what we tend to do when it comes to investing. We continually chase after the hottest returning investments. But chasing returns is like driving a vehicle using the rear-view mirror, and the results of each are often similar. Carl includes one of his drawings in the book illustrating this point.
Solution: Use a diversified portfolio based on your goals that you regularly rebalance, only making changes when your goals have changed.
Herding: We feel comforted in numbers and following the crowd. Our brains are hard-wired this way. So even if our rational mind knows the crowd is heading for the proverbial cliff, our emotions want us to run right along with them. Studies show a consistent pattern of the masses moving their money to and from investments at the wrong time. Herding is what led investors (including retirees!) to load up on tech stocks toward the end of the 1990s, just before the accompanying crash. Similarly, more and more people began buying real estate in the mid-2000s with a collapse in real estate prices following soon after. This herding tendency is as strong, if not stronger, during market declines with the masses consistently taking their money out of investments near market bottoms. These cycles have repeated themselves throughout history and are fed by the herding mentality.
Solution: Be aware of our tendency to want to follow the crowd and draw upon history to remind us that when it comes to investing, herding almost always leads to disastrous results.
Searching for the Perfect Investment: There is no such thing as a perfect investment but we spend plenty of time trying to find it. Instead of spending time working on sound money management principles like living within our means, paying down debt and consistently putting away money for our most important financial goals, we are often tempted to forgo these principles with hopes that the perfect investment can save us. The odds of finding the perfect investment to make up for poor cash management is like playing the lottery with our financial lives. Good money management with average investments will give us a higher probability of reaching our financial goals than spending a bunch of time looking for “the next Apple or Google” while maintaining poor money management habits. We run into people all the time hunting for great investments even as they ignore more fundamental issues in their financial situation. Several years back, I met a retiree who told me he needed to generate $50,000 per year from his investments that totaled around $150,000. I told him there is no investment in the world that can reasonably be expected to generate that kind of income and that he either needed to significantly reduce his cash flow requirements or expect to be broke in about 3 years. This is an extreme example and thankfully I have not encountered another case quite that extreme, but we often warn people against needing or expecting high returns to meet their financial goals. Carl states it well in The Behavior Gap when he writes, “…the odds of achieving financial success are much higher if we simply work, save, and build an investment portfolio based on reality.”
Solution: Use good money management principles as the foundation for your financial success and avoid the belief that high returns and beating the markets are the keys to success.
There are several other behavioral mistakes that Carl addresses in his book in an entertaining way. The Behavior Gap also includes a section on how to use money to bring more happiness into our lives that compliments and adds to my previous blog, Happy Money. The Behavior Gap is a quick read that will often have you nodding your head in agreement as it discusses many of the mistakes we tend to make with money. Armed with an increased awareness of these mistakes, it is my hope that you will improve how you think about money and investing to help close your “Behavior Gap”. If you have any questions or comments about this blog or the book, do not hesitate to contact me. You can reach me at firstname.lastname@example.org.
Disclosure: All investing involves risk, including the possible loss of principal. There is no assurance that any investment strategy will be successful. A diversified portfolio does not assure a profit or protect against loss in a declining market.