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Investor Behavior: The Debate That Matters Most

The search for the best investment process is a distraction to the really hard work of helping clients behave correctly.

Carl Richards, 04/07/2011

This article first appeared in the April/May 2011 issue of Morningstar Advisor magazine. Get your free subscription today! 

One of the very first things that comes up when I talk to other advisors about closing the Behavior Gap (the gap between investment returns and investor returns) is index funds--they are the answer. The assumption is that taking a passive approach to investing leads to better investment behavior. While there might be some truth to that argument, it misses the point: The investment process we advise people to use only matters to the degree that it influences our behavior and our clients' behavior.

For some advisors (and by extension their clients), the academic evidence behind passive asset-class investing is so strong that it helps them behave correctly when times are tough. When they have bad performance, they know it's because the markets were down, and they don't have to wonder if the performance was better or worse because a manager has lost "the touch." For other advisors, the idea of having managers use their judgment, experience, and skill--taking an active approach to investing--inspires confidence in tough markets, a bit like knowing that they still have an experienced pilot on the plane even though most of the flying is done by the computer.

But this entire debate between passive and active misses the point: You can spend a lifetime trying to find the "best" investment approach only to blow it up completely with one big behavioral mistake at the wrong time. No matter how solid the approach, there will be tough times. There will be times when we are tested. Sometimes, it's the result of corrections and bear markets. Other times, it will be due to underperformance in up markets. But no matter the cause, what really counts is how we respond during those moments when our confidence is tested. That is when good investment advisors earn their pay--by helping clients avoid the costly mistake of buying high and selling low.

To some degree, the search for the best process is a distraction to the really hard work of helping clients behave correctly. If 83% of assets going into mutual funds are directed by advisors, there is a huge opportunity for advisors to rid the world of negative behavioral alpha, to close the Behavior Gap. I have decided that I will leave the debate over the best way to invest to people much smarter than me and instead focus on solving a much simpler problem, and one that will reward my clients with higher lifetime returns than 99% of their neighbors: behaving correctly.

Yes, the investment process matters. Yes, having a healthy debate regarding the best way to invest matters, but in the end, these things only matter to the degree that they give us the confidence to walk people in off the ledge when they are about to jump.

Carl Richards believes that the world is a better place when people make smarter decisions about their money. That's just one of the big ideas he promotes at BehaviorGap.com, where Richards asks tough questions about financial planning and investor behavior. Richards puts his ideas to work in the real world through his firm, Prasada Capital Management.

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