When looking at past performance of funds or stocks, you would probably think that the return shown is what each investor achieved by investing in that fund. If you thought that, you would be partly right. Good investors will have achieved that return, bad investors are likely to have under performed. The reason for this is something called the behavior gap.
The behaviour gap exists because investors do irrational things. The secret to good investing is to pick a suitably diversified investment portfolio commensurate with your appetite for investment risk, and to then leave this. This is easier said than done – partly because it is boring, and partly because it doesn’t feel like you are doing anything (humans get satisfaction from doing and changing things). When you have amassed a large sum of money (often later in life as you approach retirement), falls can also be particularly hard to stomach (when you’re just starting out at 21 a 30% fall in your £1,000 pension is not likely to affect you mentally nearly as much as a 30% fall on your £500,000 pension).
Morningstar have recently published their‘Mind the Gap 2024’ reportwhich attempts to quantify the cost of the behaviour gap (their study is mainly focused on US investors). Over the past decade, they estimate that investors lost 1.1% per year due to the behaviour gap. This equates to 15% less return over the decade than had they done nothing and this gap will only grow wider as time goes on and compounding has more and more time to take effect.
The main problem is investors trying to time investment markets. The report shows that investors were confidently adding to their investments during 2019 and the start of 2020. As Covid struck and the market fell, investors were pulling money out (i.e. poor investment behaviour – you should in fact be doing the opposite if you have spare capital) believing markets were continuing to fall. In fact, markets began to rise and investors waited too long to reinvest back into markets. The chart below fromVanguardillustrates just how detrimental selling after a fall in markets and waiting for a recovery during 2020 was, the return is less than half than what it would have been if you would have just done nothing:
More recently, you may have seen in the news that theJapanese stock market had its worse 2 day lossesin history. The market fell 18.2% across 2 days. As of today the Japanese market has recovered c21% and is nearly back at the level it was pre crash. Clearly, panic selling after a loss in this instance would have cost investors dearly.
How can you avoid this? The best way is to invest in a suitably diversified investment portfolio with the appropriate level of investment risk. That way, the downturns when they do happen (and they will, markets fall as well as rise) will be easier to stomach.
You can also choose to employ a financial adviser. As well as offering cashflow plans via MyChoice, we are able to offer a full advice service that is discounted for employees of Phoenix. Working with an adviser will mean that you can avoid the mistakes that most investors make and avoid costing yourself a lot of money – an adviser who can teach and advise you to stay the course during periods of extreme market downswings will be worth their fee many times over across a lifetime.
