Understanding the Investor Behavior Gap: Why Emotions Can Derail Your Returns

If you’re nearing retirement, every market dip can feel personal. You've worked hard to build your nest egg, and watching it shrink—temporarily or not—can trigger a cascade of emotion-driven decisions. It’s easy to blame the economy or world events for declining portfolio values. But often, the bigger threat to long-term returns isn’t what’s happening outside—it’s how we respond inside. Emotions can lead investors to make costly decisions at the worst possible times. Understanding these behavioral pitfalls is key to avoiding them.

Even seasoned investors can fall into predictable patterns when markets tumble. That’s because we all carry certain hardwired mental biases, which are psychological shortcuts that help us make decisions quickly and avoid short-term dangers. While beneficial in day-to-day survival, these natural tendencies can hinder sound investment decisions. A few of the most common investor biases that can lead to poor financial outcomes are:

• Availability Bias or Recency Effect: We tend to give more weight to recent events, which are freshest in our minds. If the market has been declining, we might believe it will continue to do so indefinitely, leading to overly pessimistic decisions.​ That feeling of “this will never end” can push people to make long-term decisions based on short-term performance (i.e., sell when it would have been better to hold steady).
• Loss Aversion: Humans tend to fear the pain of a loss more than the joy that is felt from a gain. In other words, the pain of losing money often feels more intense than the pleasure of gaining the same amount. This can cause investors to misjudge their tolerance for risk, causing them to sell investments prematurely during downturns to avoid further perceived losses, or avoid risky investments to mitigate potential losses.
• Overconfidence: Sometimes, we believe we can outsmart the market based on past successes, leading to risky moves that aren't grounded in thorough analysis.​ This overconfidence leads us to lose perspective about our abilities or knowledge.
• Hindsight Bias: After a market drop, it's easy to believe the signs were obvious and that we should have predicted it. We create a narrative around the events to make the experience straightforward and predictable. This can lead to misplaced confidence in forecasting future market movements.​
• Herd Mentality: When headlines scream bad news, it’s natural to feel “safer” following the crowd. If everyone is selling, we might feel compelled to do the same, even if it's not in our best interest.​
• Ambiguity Aversion: We prefer the familiar over the unknown. This can lead to a “home bias” within our portfolio, which is an over-concentration in domestic markets or familiar industries, reducing diversification.​

All of this can lead to what’s known as the “behavior gap,” which is the concept that investor behavior may cause underperformance relative to index market returns. Studies on retirement spending from investment portfolios typically assume that retirees are rational investors who never panic and sell their stocks after a market downturn. For many retirees, this may not describe their reality.

In times of market volatility, it is important to stick with your financial plan. While staying the course can feel counterintuitive, it is often the best move. It is crucial to avoid making impulsive decisions based on short-term market movements. Market downturns, while unsettling, are a natural part of the market cycle and your investment journey. By acknowledging our inherent biases and implementing strategies to counteract them, we can navigate periods of uncertainty with greater confidence and resilience.