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Is the Behavior Gap Real?

In case you haven’t run into it yet, let me introduce you to one of my new favorite blogs: Behavior Gap. The primary idea behind the site is that investors, on the whole, tend to actually underperform the investments they own.

Why? In short, because they buy and sell them at the wrong times. In other words, people chase performance—buying after a fund has just done well, and selling after it’s just done poorly.

Potential issues with the Behavior Gap concept

Yesterday’s post at Behavior Gap quoted a study by Dalbar which calculates the behavior gap as a roughly 7% annual difference in investor returns as compared to investment returns over the last 20 years.

A few readers asked some very intelligent questions in the comments: How is that possible? Isn’t it a given that investors (as a group) earn precisely the same return that their investments (as a group) earned over a period?

The answer to that question is of course “yes, before expenses.” A significant part of the 7% gap in the Dalbar study is the result of the fact that the study includes sales charges and expense ratios.

Issues with the study

However, there are a couple legitimate issues that can be raised as to the study’s methodology. First, it uses the S&P 500 as the measurement for “the market.” As a result, if large-cap stocks outperform small- and mid-cap stocks over the period, the gap will look larger than it really is.

Second, when calculating “investor return” the study only uses returns earned by investors in mutual funds. As such, any holdings in the form of individual equities–whether by individual investors or by large institutions like pension funds–are not considered.

Using another study

Conveniently enough, the Dalbar study isn’t the only one to have attempted to tackle this concept. A few months back, I linked to a study done by Ilia Dichev (an Accounting professor at the University of Michigan).

Dichev’s study attempts to calculate the behavior gap (or lack thereof) by comparing a time-weighted return for the entire market to a dollar-weighted return for the entire market. What he finds is a much more modest gap: 1.4% annually. However, as we’ve seen, even a 1% difference per year can crush your total wealth accumulation.

Still, the question arises as to where this difference comes from. After all, if all transactions in the market are zero-sum (that is, if somebody is selling a share of stock, somebody must clearly be buying it), then wouldn’t the time-weighted return and dollar-weighted returns be the same?

Well, yes, they would. But here’s the catch: Not all transactions are zero-sum. When companies issue new shares of stock or repurchase shares of their own stock, money is literally added or subtracted from the market.

And guess what? Companies tend to issue shares of stock when the market is high and buy shares of their own stock when the market is low. Hence, a very real (though perhaps significantly smaller) Behavior Gap.

A more important question

Granted, there still may be issues with Dichev’s study. I haven’t found any, but I could be missing something.

However, what I know for a fact is this: Even if the Behavior Gap turns out not to exist in total, it most certainly exists for a great many investors. And that alone is enough to make it worthwhile to discuss.

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  1. Hi Russ.

    I have to agree, my anecdotal evidence absolutely confirms that the Behavior Gap is very real.

    Also, thanks for sharing the link to the Dalbar study. 🙂

  2. Nice post. I’m also a fan of Carl’s work at

    I believe the BehaviorGap concept is sound, though the details can be dissected and interpreted a million different ways. As a financial advisor that has brought on clients coming from other advisors, I’ve seen the BehaviorGap as evidenced by clients’ statements and their history of buying when they should be selling and vice versa.

    Here’s another resource that supports the concepts of the BehaviorGap:

  3. No worries, Mike. And thanks for the link to my site

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