Mind the gap

**Image by Carl Richards, Buck’s Blog at the NYT. Check out the blog for more simple yet powerful investment messages.

Behavior dominates investor under performance. As the simple yet powerful chart above so nicely illustrates investor returns are lower than the very investment classes they are invested in regardless of the absolute performance these asset classes. This is the so called behavior gap. All of us have a host of behavioral biases that are constantly driving us to make the wrong investment decisions. We are not the rational automatons that efficient market theory or classical economic theory assumes us to be. In order to be successful every investor needs to have a system or game plan to deal with their own behavioral biases even if some elements of that plan are not completely rational. Today I’ll share with you how a common trait of today’s markets leads to some of my behavioral issues and how I deal with them.

First lets take a look just how bad the behavior gap is. The table below shows mutual fund investor performance versus actual average mutual fund performance. Put aside the fact that most of the time the average mutual fund fails to match the performance of the market. This under performance is over and above any mutual fund issues.

Looking at the 10yr performance investor returns are lower than the fund returns in all cases except in balanced funds. Across all funds investors underperformed by approx 1.5% a year over 10yrs. That is a huge difference. The major reason for this discrepancy is that investors tend to buy high and sell low due to a host of behavioral biases.

A great source of information on behavioral issues faced by investors is this compilation of writings from James Montier. Its a long and free version of his book The Little Book of Behavioral Investing. In these writings Montier goes through many of the behavioral issues investors face by looking at seven sins often committed by mutual funds. Read, then re-read, then re-read these notes. It will be a great investment of your time. One common trait in today’s markets that I deal with personally is too much information.

Investor’s today have more information than ever before. The financial media, investment blogs, social networking, stock analysts, modern corporate disclosure rules all inundate investors with information day in and day out. But one of the biggest lessons in behavioral investing is that more information does not lead to more accuracy. In truth its the exact opposite. More information leads to over confidence which leads to less accuracy. As Montier says;

All too often it seems that we thirst for more and more information. Investors appear to believe that they need to know more than everyone else in order to outperform. This belief actually stems from an efficient markets view of the world. If markets are efficient, then the only way they can be beaten is by knowing something that everyone else doesn’t know i.e. knowing more information or knowing the future. So it is all the more paradoxical to find fund managers regularly displaying such a belief. The psychological literature suggests that we have cognitive limits to our capacity to handle information. Indeed we seem to make the same decision regardless of the amount of information we have at our disposal. Beyond pretty low amounts of information, anything we gather generally seems to increase our confidence rather than improve our accuracy. So more information isn’t better information, it is what you do with it, rather than how much you collect that matters.

I deal with the issue of too much information leading to over confidence in several ways.

• Use the off button. I heavily limit my intake of TV news and financial TV news like CNBC and Bloomberg. Most guests on financial TV are biased and are talking their book anyway. Its not worth listening to 95% of them. Instead I digest most of my financial news through reading. In my readings I tend to stick to longer term or fundamental investors instead of more news oriented readings. I do watch one financial news show. Tom Keene on Bloomberg at 12:00PM Eastern time. His show is macro focused, my hobby, and the quality of his guests are top notch.
• I limit my trading. The more you trade the more chances you have of being exposed to over confidence caused by too much information. This is one of the reasons I always automatically reinvest dividends. While in theory one can achieve higher returns through active reinvesting I think it exposes the investor to making too many behavioral mistakes. For example, with even a highly concentrated portfolio of 10 dividend stocks, active reinvesting would require 40 trades a year, assuming dividends are paid quarterly. That’s 40 decisions exposed to behavioral mistakes. No thanks. Even in my trading account, I don’t trade nearly that much. When I do trade, I try and take advantage of other investor’s mistakes, e,g like when the VIX spiked to over 30 on the Japan earthquake and investors indiscriminately started selling.
• I take a longer term view of my investments. I strive for as long a holding period as possible with my investments. Besides putting new money to work I haven’t traded in my core dividend portfolio since 2008. With the average holding period for stocks now at less than a year this put the odds in favor of the long term investor.

These techniques have served me well over the years. But I’m not immune to falling prey to my biases. I work at them all the time. It is not easy to over come your built in inherent behavioral biases. The best thing you can do is first to learn what the common behavioral biases are, see which ones most apply to your individual personality, and then develop your own tool and techniques to keep them at bay. Your solutions may not be rational but they will help keep you solvent. I’ll post more on behavioral issues but that’s a good start for now.