What is Behaviour gap?

The behaviour gap is the difference between the return an investment produces and the return the people holding it actually receive. A fund's published return assumes someone bought at the start and held throughout. Real investors add money, take it out and switch between funds, often at moments driven by emotion: buying after prices have risen and selling after they have fallen. Because more money is invested during the bad stretches and less during the good ones, an investor's own result can lag the fund's, even though both own exactly the same thing.

Say a fund rises 50% in year one and falls 20% in year two. Over the two years it turns $1 into $1.50 and then into $1.20, a total gain of 20%, or roughly 9.5% a year. Investor A puts in $10,000 at the start and leaves it alone: $10,000 grows to $15,000, then falls to $12,000, a profit of $2,000. Investor B also starts with $10,000 but, encouraged by the strong first year, adds another $10,000 at the end of it. The account goes from $15,000 to $25,000, and the 20% fall takes it to $20,000. Investor B has put in $20,000 and has $20,000 left, a return of zero on a fund that gained 20%. That shortfall is the behaviour gap.

The gap is not a fixed number and is hard to measure precisely. Estimates usually compare a fund's published return with a money-weighted return, a measure that accounts for when and how much money flowed in and out. Not every difference is a mistake: regular contributions from a salary or withdrawals in retirement also change the timing of cash flows without being emotional decisions. The gap can occasionally be positive, if an investor happens to add money just before a rise. A common misunderstanding is that it affects only beginners. Experienced investors feel the same pull during sharp falls.

For a private investor building a long-term portfolio, the behaviour gap is one of the few parts of the result that depends entirely on the investor. Large declines are where it tends to open up. The S&P 500 fell 54.6% from peak to low, with dividends, in 2007–2009, and selling near a low turns a temporary fall into a permanent one: a 55% loss needs a 122% gain to recover. Investors who choose an allocation they can hold through falls of that size are less likely to sell at the bottom. Common approaches include automatic regular investing, a written plan and periodic rebalancing, which means trading back to the original target mix of assets.

By Dr. Harry Hamann, MBA

What causes the behaviour gap?
Mainly emotional timing: adding money after strong gains, when prices are high, and selling after declines, when prices are low. Chasing recently popular funds and frequent switching between strategies widen it further.

Is the behaviour gap the same for every investor?
No. It depends entirely on when each person buys and sells. Two investors in the same fund can earn very different returns, and an investor who rarely trades will have a gap close to zero.

How do investors reduce the behaviour gap?
Common approaches include investing fixed amounts on a regular schedule, writing down a plan before markets fall, choosing a level of risk that is tolerable in a steep decline, and rebalancing on a set timetable rather than reacting to headlines.