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Efficiently Harnessing Market Returns for Investors.

Behavioral Finance

Behavioral Gap

Capital markets have historically provided very attractive return opportunities to investors. Unfortunately, if we look at the actual returns that investors experience over a full market cycle, they are often far below the market returns.

One of the reasons is fees, but another has to do with the presence of behavioral biases which we all share as a result of simply being human. For example, if we gathered a random sample of the driving age population and asked them each individually how they would assess their driving abilities, we should expect to find that about 70% think they are better than average drivers. By definition, we know that 70% cannot be better than average. Thus there is an inherent overconfidence bias at large in the population. However, this overconfidence is not entirely bad for some things, but with investments, when biases such as this creep into our decisions it can wreak havoc with the portfolio.

The field of behavioral finance is a branch of psychology that examines these biases and attempts to explore the ways in which investors act irrationally and interpret the consequences of these actions.

The following table shows some common biases and their potential impacts on an investment strategy:

Behavioral Hurdles
Behavioral Bias Definition Investment Impact
Overconfidence Attributing more of our skill to the situation than is warranted. More frequent trading = higher costs.
Loss Aversion We derive more pain from a loss than we do happiness from an equal sized gain. It's been shown that investor should be risk averse, but they are usually loss averse. There is a difference between these two. Holding losing investments / holding too much cash. But then taking unwarranted risks.
Herding A natural desire to conform socially. Investing in bubbles.
Familiarity Finding comfort in things that we are more familiar with. Lack of diversification.

As advisors, we need to understand that these biases are a very real part of the investment experience. By developing a financial plan and helping the investor maintain the appropriate asset allocation through multiple market cycles, we can assist in overcoming many of these biases, or at the very least, minimize their negative impact.

Acting rationally and keeping emotions out of the process can position the investor to capture market returns that will help them achieve financial goals. The chart below shows rolling 20-year returns of a portfolio that is made up of 60% U.S. stocks (S&P 500 Index) and 40% U.S. government bonds (U.S. Treasuries).

Each of these data points represents the return that would have been achieved over the 20 years ending at that point assuming the investor continually rebalanced this moderate portfolio and maintained that allocation throughout the period. The return for the most recent 20-year period ending May 2012 was 7.72%. Notice that the lowest return observed for any 20-year period was approximately 4%. That was the return associated with making an initial investment just prior to the Great Depression and holding for 20 years. The average return for all periods was 9.35% and there are plenty of periods with returns that were far better than that. Bear in mind that each of the 20-year periods contains multiple market cycles that came complete with numerous episodes of making and losing money in the markets.

In our opinion, the only way to ensure that you have a chance of earning an acceptable return over the long term is to remain invested and allow the markets to work for you. Long term market success has little to do with near term factors such as: who is in the Oval Office, what effect climate patterns are having on retail sales, or whether Europe solves its debt crisis in 2012, although the media would have us think differently. Success is primarily related to asset allocation and an investor's ability to maintain it through difficult times only modifying it as their personal situation, not as the markets would dictate.

Understanding the role that behavioral finance plays in our investment process can greatly enhance our chances of success and of meeting long term financial objectives. At Garde Capital, it is always our aim to apply the principles learned in this fascinating field of study in order to help our clients get the most out of their investment experience.

Morningstar Direct. Note that this analysis is using indexes which are not investable. Actual returns would vary due to fund management fees, advisory fees, and timing of rebalancing. Past performance is not an indicator of future results.