When you think of Sir Isaac Newton, the words brilliant or genius likely come to mind, right? Newton’s theories on the laws of gravity and motion helped explain planetary movements around the sun, and he’s even credited with inventing the reflecting telescope.
But when it came to managing his personal investments, some of Newton’s decisions were less than stellar. Swept away by the widespread enthusiasm for the South Sea Company, a company with commercial ties to South America, Newton invested nearly 40 percent of his wealth in the company’s shares; when things went – well, south – and Newton sold his shares in 1720, his losses totaled more than $3.6 million (in today’s dollars). Looking back on this experience, Newton apparently quipped: “I can calculate the motions of the planets, but I cannot calculate the madness of men.”
If this story sounds familiar, then you are on to something. Newton’s investment behavior nearly 300 years ago is one that many investors can relate to today. Newton impulsively joined the masses in both buying and selling shares of the South Sea Company, despite the adverse outcomes. This kind of investment behavior is what behavioral psychologists call herding.
What Are the Implications of Herding?
Herding is one of the key contributors to a common malady called the investment gap – that is, getting short-changed on overall returns over time. The investment gap is a shared experience among many workplace retirement-plan participants and other personal investors today. For example, the broad U.S. equities market (S&P 500) has advanced by an average of 8.50% in the last ten years (through December 31, 2017); yet, in the same time frame, the average equity fund investor has earned only 4.88% according to Dalbar’s “2018 Quantitative Analysis of Investor Behavior.” What this investment gap of 3.62% means for a 401(k) plan participant who started with a balance of $100,000 in this period (expenses not included), is an earnings shortfall of about $65,000.
What Else Causes the Investment Gap?
While we are on the topic of loss, another contributor to the investment gap is loss aversion. No one likes to lose something they own, right? In fact, behavioral psychologists Daniel Kahneman and Amos Tversky’s research on this topic found that the emotion behind a loss is twice as impactful as that evoked from a similar gain. Perhaps that is why some investors and plan participants yanked $36.3 billion in U.S. based equity funds and ETFs in June of this year – the largest withdrawal of this kind since October of 2008.
How Do We Close the Investment Gap?
While we have some perspective on what causes an investment gap, the practical – and most pressing – question remains: How can investors close the investment gap? Here are a few tips on this topic:
- Don’t waste your pain. Think back on some of your painful experiences from market downturns over the years, say 1987, 2000 or 2008. Having the benefit of hindsight now, if you could change one decision you made during one of those challenging periods, what would you do differently? How does this perspective guide your investment decisions now?
- Identify how significant of a role investments play in reaching your long-term goals, like retirement. Nearly half of workplace retirement-plan participants say they are on track for retirement because of their investments’ performance in recent years. Plan sponsors (the stakeholders who oversee retirement benefits) feel differently, however: 54 percent believe a majority of their participants will need to delay retirement – primarily due to a lack of personal savings. While you can’t control the ups and downs of the market, you can control how much you save toward your long-term goals. In 2019, you can contribute up to $19,000 (or up to $25,000 if you are age 50) toward your workplace retirement plan, such as a 401(k) or 403(b). Here are some additional details from the IRS.
- Challenge your thinking when adversity strikes. On May 6, 1954, Roger Bannister, a British middle-distance athlete, did the unthinkable – something many assumed impossible for decades: he broke the four-minute mile. Just 46 days later, Australian runner John Landy did it, too. In the last half-century, over 1,000 runners have accomplished the same feat. When the next downturn in the equities market occurs (as it has about 12 percent of the time in 60-month rolling periods, according to data from Ibbotson) and others begin to cast doubts on getting ahead financially, how will you respond? Rather than letting the mood of the moment get the best of you (like Newton), channel the determined mindset of these athletes—keep your focus on what you want to accomplish in the long run, and why this goal is meaningful.
It’s also important to realize you don’t have to close the investment gap alone. If you would like to learn more about how to manage your investment allocations more effectively and ensure your financial plan is on track for future success, reach out to a CFP® professional in your area today.