The Investor Comes First: Rethinking the Behavior Gap

Leading investments thought leader Cliff Asness once said, “People are not crazy, they’re just human.” That insight is at the heart of the so-called Behavior Gap.

The Behavior Gap—a term popularized by Carl Richards—refers to the difference between an investment’s return and the return an investor earns in that investment. Most of the time, investor returns are lower. And most of the time, the blame is placed squarely on the investor for being emotional or irrational.

That’s not entirely fair. It might even be mostly wrong.

There’s plenty of blame to go around—and it starts with the information investors are given. Most investment proposals showcase trailing performance, often the past three years. The problem? Three-year performance tends to mean-revert. In other words, the investments that have performed well over the past few years tend to underperform moving forward, and vice versa. Market leadership shifts, and individual investments—whether stocks, mutual funds, or ETFs—tend to follow behavioral cycles.

Now, the turning point isn’t always exactly three years, but historically it’s been a useful proxy.

So how do we fix this?

One step forward is to focus more on forward-looking expected returns, or in fancier terms, capital market assumptions (CMAs). No one knows the future with certainty, of course. But valuation-based indicators, for example, have historically been more predictive of long-term returns than simply extrapolating recent performance.

Here’s the frustrating part: Even professional investment teams often fall into this trap of "chasing performance."

Many due diligence teams—whose job it is to evaluate managers and funds—continue to favor those that have outperformed over the trailing three years. These are professionals, often with CFA designations, and fiduciary obligations to put the client first. Yet time and again, the easier path is to recommend what's already worked, rather than what’s most likely to work going forward.

And it's not just analysts. Many portfolio managers do the same. A disciplined, differentiated manager shouldn’t feel compelled to window-dress a portfolio by holding recent winners just for appearances. But for too many, career risk and comfort take precedence over the craft of managing money.

The financial media doesn’t help either. Lists of “top funds” are often just lists of the best performers from the last three years. No surprise what happens next.

Even investment committees—which often have real influence over strategy selection—rely heavily on past performance. Despite reviewing a range of inputs, trailing three-year performance still tends to be a primary if not deciding factor.

Bottom line: The Behavior Gap is real. But the burden shouldn't fall solely on the shoulders of individual investors. Many investment professionals—those who should know better—share the blame. And that’s a behavior gap worth closing.