Oct 28, 2024 | 7 min read
Some young investors might think that successful investing is all about picking the right stocks or timing the market perfectly. But here's a surprising truth: your own behavior could be the biggest factor in your investment success – or failure. This is where behavioral coaching, a key service provided by financial advisors, comes into play.
According to Vanguard's Advisor's Alpha research, behavioral coaching can potentially add a whopping 1.5% to your annual returns. That's more than any other strategy in the advisor's toolkit we discussed in our prior blog post here. But what exactly is behavioral coaching, and why is it so powerful? Let's dive in.
Understanding Behavioral Coaching
Behavioral coaching in investing is all about helping you make rational decisions in an often irrational market. It's about keeping your cool when everyone else is panicking, and staying grounded when euphoria is in the air. In essence, it's about protecting you from your own worst enemy in investing: yourself.
Why We Need Behavioral Coaching
Humans are emotional creatures, and investing at times can feel like an emotional rollercoaster. We're hardwired with certain biases that, while useful in other areas of life, can be detrimental to our investment success. Here are a few common behavioral pitfalls:
Loss Aversion We feel the pain of losses more acutely than the pleasure of gains. This can lead to selling investments in a panic during market downturns.
Recency Bias We tend to give more weight to recent events. After a long bull market, we might think stocks will go up forever. After a crash, we might think they'll never recover.
Herd Mentality We're social creatures who often follow the crowd. In investing, this can lead to buying high (when everyone's optimistic) and selling low (when everyone's pessimistic).
Overconfidence We tend to overestimate our own abilities. This can lead to excessive trading or taking on more risk than we can handle.
The Cost of Behavioral Mistakes
These behavioral biases can be incredibly costly. To illustrate this point, let's look at some data:
Annualized shortfalls of investor returns versus fund or time-weighted returns
Notes: The time-weighted returns underlying this figure represent the average fund return in each category. Investor returns assume that the growth of a fund’s total net assets for a given period is driven by market returns and investor cash flow. An internal rate-of-return function calculates the constant growth rate that links the beginning total net assets and periodic cash flows to the ending total net assets. Discrepancies in the return difference are due to rounding. Fund categories include fund-of-fund assets and cash flows to best capture investors’ experience when that structure is common.
Source: Vanguard calculations based on data from Morningstar, Inc.
This chart shows the "behavior gap" – the difference between the returns of the average investor and the returns of the funds they invest in. As you can see, across various types of equity funds and allocation strategies, investors consistently underperform their own investments.
For example, in U.S. large-cap equity blend funds, the average investor underperformed by 0.84% over ten years and 0.12% over one year. The gaps are even larger for other categories, reaching as high as 2.47% for U.S. small-cap value funds over ten years.
Why does this happen? Often, it's because investors buy and sell at the wrong times, driven by emotions rather than a sound investment strategy. They might panic and sell during a market downturn, locking in losses and missing the eventual recovery. Or they might pile into a "hot" investment after it's already had a big run-up, just in time for a correction.
The Role of Behavioral Coaching
This is where behavioral coaching comes in. A skilled financial advisor acting as a behavioral coach can:
Provide Perspective When markets are volatile, your advisor can remind you of your long-term goals and the historical resilience of markets.
Create a Solid Plan Having a well-thought-out investment plan makes it easier to stay the course when times get tough.
Set Realistic Expectations Your advisor can help you understand what kind of returns and volatility to expect, reducing the likelihood of panic or euphoria.
Reframe Your Thinking Instead of seeing market downturns as disasters, your advisor can help you view them as opportunities to buy investments at a discount.
Act as a Emotional Buffer By delegating investment decisions to an advisor, you create a buffer between your emotions and your money.
Real-World Impact of Behavioral Coaching
Let's look at a concrete example of how behavioral coaching can make a difference:
Imagine it's March 2020, and the stock market has just experienced one of its worst weeks ever due to the COVID-19 pandemic. The S&P 500 is down about 30% from its peak. You're scared and thinking about selling your stocks to prevent further losses.
Scenario N°1: Without Behavioral Coaching You sell your stocks, moving to cash. The market recovers rapidly over the next year, but you're too nervous to get back in until it's clear the recovery is real. By the time you reinvest, the market is already up 60% from its low.
Scenario N°2: With Behavioral Coaching Your advisor reminds you of your long-term plan and the historical pattern of market recoveries. They encourage you to stick to your strategy and even consider buying more while stocks are "on sale." You stay invested and even add more to your portfolio during the dip.
One year later, in Scenario 1, you've locked in a 30% loss and missed out on a 60% recovery. In Scenario 2, not only have you recouped your paper losses, but you're now significantly ahead.
This isn't just a hypothetical scenario. Vanguard's research has shown that advised clients were significantly more likely to stay the course during the COVID-19 market crash compared to self-directed investors.
Strategies for Self-Coaching
While having a financial advisor can be incredibly valuable, there are also strategies you can use to "coach" yourself:
Create a Written Investment Plan Document your goals, risk tolerance, and investment strategy. Refer back to this when you're tempted to make emotional decisions.
Automate Your Investments Set up automatic contributions to your investment accounts. This reduces the temptation to try to time the market.
Limit Your Media Consumption Constant exposure to financial news can increase anxiety and lead to poor decisions. Consider checking your portfolio and the news less frequently.
Practice Mindfulness Techniques like meditation can help you become more aware of your emotions and less likely to act on them impulsively.
Keep a Decision Journal When you make investment decisions, write down your reasoning. Review this periodically to learn from your successes and mistakes.
Use Rules-Based Decisions For example, you might decide in advance to rebalance your portfolio if it drifts more than 5% from your target allocation.
The Long-Term View
As a young investor, you have a powerful advantage: time. The longer your investment horizon, the more you can benefit from behavioral coaching. By avoiding major mistakes early in your investment journey, you allow the power of compound interest to work its magic over decades.
Consider this: if behavioral coaching can add 1.5% to your returns annually (as Vanguard's research suggests), over 30 years that could potentially more than double your wealth compared to investing without this guidance.
Final Thoughts
Investing successfully is not just about what you invest in, but how you invest. Your behavior – your ability to stick to your plan through market ups and downs – can have a bigger impact on your long-term wealth than picking the "right" stocks or timing the market perfectly.
Behavioral coaching, whether from a financial advisor or through self-discipline, can help you navigate the emotional challenges of investing. It can help you avoid costly mistakes, take advantage of market opportunities, and stay focused on your long-term goals.
Remember, the most sophisticated investment strategy in the world is worthless if you can't stick to it. By mastering the behavioral aspects of investing, you're not just improving your financial outcomes – you're gaining peace of mind and confidence in your financial future.
So next time you're tempted to make a hasty investment decision based on fear or greed, take a step back. Consider your long-term plan, your goals, and the historical resilience of markets. Your future self – and your investment returns – will thank you for it.
For a more comprehensive look at how financial advisors can add value through behavioral coaching and other strategies, check out our in-depth blog post: The Hidden Value of Financial Advisors: More Than Just Investment Returns.
At Israilov Financial, we understand the crucial role that behavior plays in investment success. We are skilled in behavioral coaching, helping clients navigate market volatility and make rational decisions aligned with their long-term goals. If you're interested in learning how we can help you develop a disciplined investment approach and avoid common behavioral pitfalls, schedule your free discovery meeting.
IMPORTANT DISCLAIMERS
Past performance is no guarantee of future returns
The graphs and charts in this commentary are for illustrative purposes only and not indicative of any actual investment. Index returns do not reflect any fees, expenses, or sales charges. It is not possible to invest directly in an index. Stocks are not guaranteed and have been more volatile than other asset classes. Historical returns were the result of certain market factors and events which may not be repeated in the future. Financial professionals are responsible for evaluating investment risks independently and for exercising independent judgement in determining whether investments are appropriate for clients.
This material is intended for information purposes only, and does not constitute investment advice, a recommendation or an offer or solicitation to purchase or sell any securities.
Disclaimer: Investments are not guaranteed and are subject to investment risk, including possible loss of the principal amount invested. Past performance is no guarantee of future results. All allocations and opinions expressed are as of the date of this presentation and subject to change. The information contained herein does not constitute investment advice or a solicitation. Information obtained from 3rd parties is believed to be accurate, but has not been independently verified.
The opinions expressed in this article are for general informational purposes only and are not intended to provide specific advice or recommendations for any individual or on any specific security. The material is presented solely for information purposes and has been gathered from sources believed to be reliable, however Israilov Financial LLC cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. Israilov Financial LLC does not provide tax or legal advice, and nothing contained in these materials should be taken as such.
As always, please remember investing involves risk and possible loss of principal capital. Advisory services are only offered to clients or prospective clients where Israilov Financial LLC and its representatives are properly licensed or exempt from licensure. No advice may be rendered by Israilov Financial LLC unless a client service agreement is in place.
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