Research has suggested that investor behavior can meaningfully affect the returns investors actually realize, often in ways that fall short of the returns the underlying investments generate over the same period. The gap is widely discussed in the behavioral finance literature.
The Gap Between Investment Returns and Investor Returns
The reason is not usually about intelligence, access to information, or the quality of the underlying investments. It is about behavior. Specifically, it involves the tendency to feel most comfortable adding risk when markets have been rising, and most inclined to reduce risk when markets have been falling, which can work against long-term outcomes.
How the Pattern Tends to Play Out
Consider how this can unfold. After a long market rally, optimism tends to build, and the experience of holding stocks has felt rewarding for an extended period. This is often when investors feel most willing to take on additional risk. Then a downturn arrives. Account values decline, and holding positions can start to feel uncomfortable. The discomfort sometimes builds until selling feels not just acceptable but responsible. Once markets recover, investors who sold may wait for clearer signals before returning, which can mean buying back at higher levels than where they sold.
The underlying dynamics are rooted in well-documented aspects of human psychology. Research by Daniel Kahneman and Amos Tversky, among others, suggests that losses tend to feel more painful than equivalent gains feel rewarding. That asymmetry can shape decisions in powerful ways, particularly during volatile periods.
Why Awareness Alone Is Often Not Enough
Recognizing this tendency is useful, but awareness alone is often not enough. When markets are falling sharply, abstract knowledge about behavioral finance does not necessarily counteract the immediate emotional response. This is part of why structural approaches tend to be more reliable than willpower alone.
Key takeaway: Structural approaches like written plans, automated processes, and reduced monitoring tend to be more reliable than relying on willpower during volatile markets.
Approaches That Can Help
- Writing down an investment plan during a calm period, and committing to review that plan before making significant changes. Decisions made under stress tend to differ from decisions made with time and perspective.
- Automating contributions and rebalancing where appropriate. Systematic processes do not respond emotionally to market movements.
- Reducing the frequency of account monitoring during particularly volatile periods, recognizing that frequent monitoring does not typically improve long-term outcomes but can increase the temptation to react.
- Building a portfolio aligned with a realistic assessment of risk tolerance, considering how one might feel during market declines, not just during periods of growth.
A Note on When Changes Are Appropriate
It is also worth noting that staying invested is not always the right answer in every situation. Individual circumstances matter. Someone approaching a major financial goal, experiencing a significant life change, or whose financial situation has shifted may have legitimate reasons to adjust their portfolio. The point is not that investors should never make changes. It is that changes made in response to short-term market movements and emotional pressure tend to produce different results than changes made in response to changes in one's actual financial picture.
Long-term outcomes often depend more on staying invested through volatility than on attempting to avoid every downturn, though the appropriate level of risk varies considerably by individual.
A Plan You Can Stick With Matters as Much as the Plan Itself
Building a portfolio and a process that holds up under pressure is one of the most practical things a financial plan can do. If you want a second set of eyes on yours, we’re here.