3. Behavioral edge: getting paid to do what hurts

Level 7: The four possible edges

We come now to the edge almost nobody wants because it flatters nobody. It does not consist of knowing more or reading better. It consists of doing, with real money and at the worst possible moment, what most people are incapable of doing. The behavioral edge does not make you cleverer. It makes you the one still inside when everyone else gets out.

Why the market pays for discomfort

Let us start with the fundamental point, because almost everyone skips it. Equities return more than government bonds over the long run for one concrete reason: because sometimes they do horrible things. Between October 2007 and March 2009 the US large-cap index lost around half its value. In February and March 2020 it fell about a third in little more than a month. In 2022 it closed the year close to 18% down, with long government bonds falling at the same time.

That exposure to disaster is not a defect of the asset: it is the product you are selling. Antti Ilmanen puts it this way in his work on expected returns: the premium you collect is the compensation for owning something that loses value exactly when it suits you least, when your job is at risk and when everything else is falling too. If that stopped hurting, it would stop paying. Anyone promising you the return of equities without their falls is promising you an insurance premium without insuring anything. Discomfort is not the entry price to the market: it is the product you are paid for.

The specific moments when almost everyone sells

The theory above turns into lost money in four very recognizable situations:

• After a sharp, fast fall. People do not sell on the bad day, they sell after several weeks of bad days, when the accumulated loss is already large and the mind is looking for relief.
• After a long stretch of lagging behind. You do not even have to lose money: earning less than the neighbor for three years running is enough. That is the horizon over which patience runs out, both a private investor's and an investment committee's.
• When the story is coherent. What is unbearable is not the fall, it is the convincing explanation of why the system is broken this time. It always exists, it is always well argued and it is always signed by someone with credentials.
• When your own life is going badly too. The market usually falls when the economy deteriorates, which is to say when your job and your business are in worse shape. Selling then does not feel like panic, it feels like prudence.

Howard Marks insists on a point that fits here: to get a result different from everyone else's you have to do something different, and that means being alone and wrong for long stretches before being right. The discomfort is not a side effect of the process. It is the process.

The behavior gap: exactly what it costs

This can be measured, and it is measured by comparing two figures: the return a fund publishes, calculated from the start of the period to the end, and the average return earned by the money that was actually inside, weighted by how much capital was there at each moment. The difference between the two is the behavior gap, and it can only come from one thing: money going in and out at bad moments.

The most careful measurements of the last decade put that gap at around one percentage point a year on average. It sounds small until it compounds over twenty years. And the important detail is how it is distributed: it is almost nil in boring multi-asset funds, which people buy and forget, and it shoots up in the more volatile or thematic categories, where it reaches several points a year. The more exciting the product, the more expensive the behavior of whoever buys it.

There are much larger estimates, of four or five points a year, coming from a commercial study widely cited for years. It is worth knowing that its methodology is fairly disputed and that it probably exaggerates. The gap exists and is well documented; its exact size depends on how you measure it.

Why knowing about it is not enough

Here is the part that separates this module from a motivational poster. Knowing about the gap does not eliminate it, and there are structural reasons for that.

The first is that the decision to sell is not taken in the cold, but after weeks of losses and headlines confirming them daily. The second is that the argument for selling is always a good one: people do not sell out of stupidity, they sell out of conviction. The third is that the pressure is not only psychological but social: whoever manages other people's money answers to clients who look every quarter, and whoever manages their own answers to a partner who asks.

And the fourth, the most important: if this edge were easy, it would no longer pay. The premium exists because most people cannot hold on. A world in which everyone holds on is a world in which the expected return on equities looks like the return on government bonds.

Real case: the best fund of the decade and its investors

The best documented case is a highly concentrated US fund that was among the top performers of the 2000s, with a published result of around 18% a year between 2000 and 2009. When, at the end of that decade, the return weighted by the money actually invested in it was calculated, the result for the average investor was negative, on the order of minus 11% a year.

Both figures are correct and they do not contradict each other. The fund made 18% a year for anyone who was inside for all ten years; almost nobody was. Money poured in after the excellent years and poured out after the bad ones, and in a fund that swings that much, all that coming and going destroyed a result that was among the best of its generation.

The lesson is not that the fund was bad. It is that the best product of the decade lost money for most of the people who bought it, and not through analysis, nor information, nor fees. Through behavior.