Reducing The Behavior Gap

I’ve read a handful of books recently that have discussed the psychology of investing (Thinking In Bets, The Geometry of Wealth, The Behavioral Investor) and I’ve become more enlightened on the concept of the behavior gap. Typically, I’m more attracted to the technical books since I have more of an analytical mind. However, reading these books has turned me onto something new and I wish I would have paid more attention to the behavior gap in my earlier years of investing.

The behavior gap accounts for the difference in returns that we see in our investments when we let our emotions get the best of us. There are numerous studies that show when we succumb to our feelings our returns typically suffer. If you have a good financial advisor, a large portion of their job requirement should be to talk you off the ledge when it comes to making split-second decisions in times of crises.

A perfect example of this occurred last fall when the market dropped 20% in less than three months and subsequently rose 20% in the following three months. Do you remember how you felt then versus how you feel today?

My gut was saying “this sucks, I should do something”. My gut feeling was a basic human instinct telling me to go into self-preservation mode. Self-preservation urges animals to collect energy and resources required to prolong life as well as resources that increase chances of survival. In stock market terms this means sell when the shit hits the fan and the world looks like it’s going to end, which typically is the worst decision we can make at the time.

I finally overcame my ego and gave in years ago in favor of the passive investing style. I subsequently put 95% of my investible assets into a basket of mutual funds that never get touched outside of the occasional rebalance. I currently keep about 5% of my investible assets in my active account where I buy and sell individual stocks. This allows me to scratch my gambling itch while decreasing the behavior gap to nearly zero (and possibly negative if I outperform my passive investments).

Actively managing about 5% of my assets allows me to stay on the treasure hunt for the next Amazon or Apple. Although, I know if I ever find any treasure, my behavioral biases will tell me to lock in profits before the gains get too large for fear of losing them (self-preservation). Managing a small active account allows me to stay engaged with what’s happening in the world of stocks. If I put every penny into a passive investment vehicle I don’t think I would have the urge to constantly check Twitter about individual stocks throughout the day, and then all of you would suffer because FinTwit would be boring.

The 5% I’ve chosen is an arbitrary number and it will be different based on your own risk profile. For me it’s the level that I feel won’t sabotage my retirement account if I decide one day to gamble it all on lotto Tesla puts and blow up my entire active account.

Recognizing our behavioral biases is the first step of becoming self aware of our investing tendencies, but regardless, they are still incredibly hard to overcome.