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Richards: Don't Underestimate the 'Bad Behavior' Drag

Wed, 11 Jan 2012

Investors' bad behavior can swamp their carefully laid plans and even the best investment selections, says financial planner, New York Times blogger, and author Carl Richards.

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Video Transcript

Christine Benz: Hi I'm Christine Benz for Morningstar.com.

Investors often behave in ways that run counter to their own interests. Carl Richards, a financial planner, a blogger for the New York Times, and a contributor to MorningstarAdvisor.com has written a new book that addresses this tendency, and it's called The Behavior Gap. He is joining me via Skype to talk about it today.

So Carl, the title of the book is The Behavior Gap, and you've got a sketch in the book that looks exactly at that, and that is the difference between the investment return and investor return. What are you focusing on there?

Carl Richards: It used to be that this was a hard concept for people to understand, and now Morningstar is providing that under their return metrics or performance metrics page of each mutual fund.

Years and years ago, there was a study done by a research firm called DALBAR. It has since been repeated by Morningstar with a ... different degree of results, but they all say the same thing, and that is, often we get confused between the return that investments earn, and the return that an Investor actually gets.

So let me give you an example; let's say you have a mutual fund that has a 10-year return, and I am just going to pick a number to make the math easy, 10%. Now that's the return that you would have gotten if you had put money in on day one, 10 years ago, and left it there for 10 years. You didn't add any money, you didn't take any money out. You didn't switch to the next hot mutual or the next hot mutual fund and make all these [trades]. You just put the money in and you left it there.

Well, we can then go look and see what the average investor in that exact fund, essentially, what their return was over that same time period, and ... at least all the studies I have seen, show that ... in most cases, the return that the actual investors earned was lower.

Of course there are expenses in there, and there are some other things, but most of that, at least my experience, and I am not an academic, but my experience has been, most of that is due to poor behavior.

We are notorious for, again, selling, getting out of this fund, buying a fund that made some list of 10 hot funds you should own now, only to sell it a couple of months later when it doesn't perform up to your expectations.

So that was the original behavior gap. Label that difference there between investment return and investor return, the behavior gap.

It has grown to mean, at least to me and what the book was about, was about any behavior that got in our way of positive financial results.

Benz: The fascinating thing is that this behavior gap, in terms of magnitude, can really swamp a lot of the things that we investors focus on.

So whether it's expense ratios, which are very important, or picking one large-cap blend fund versus another, these behavior gaps can be way more impactful, but people don't talk about them or think about them quite as much.

Richards: For sure. The epiphany for me earlier on in my career, probably like nine or 10 years ago was, "Wait a second--I could own a mediocre investment, and if I just behave correctly, I'll outperform 99% of my neighbors."

And I am making those numbers up, but the issue is that it's really, really important. And I remember seeing a Consumer Reports issue on mutual fund fees, and the whole thing was about how to save a quarter of a percent here or there on fees, which is really important. But there was one sentence in there that referenced either Morningstar's version of the study or DALBAR's version of the study that said, after you found your inexpensive mutual fund, realize that poor behavior could cause you to lose 1%, 2%, 3%. But it was one sentence out of a three-page report on how to save a quarter of a point on fees.

So I think, at least the way for me to view it is, we want to eke out every single thing we can in terms of saving on fees and taxes and making wise decisions. But once we do, we have got to behave correctly, or we are going to waste all that.

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