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Investing’s Pain Gap: What You Put Up With To Earn Returns

Markets are frustrating—especially when you look at a year’s worth of returns. Year to year, you can easily experience what we call the pain gap. The key is to not let the pain gap create a behavior gap between your account and market performance.

Articles by Morgan Housel

By Morgan Housel
Partner, Collaborative Fund  |  Published: February 1, 2019

The pain gap is another way to look at market volatility. It’s the difference between a year’s return and the range of market closes each year.

If the behavior gap explains the difference between the stock market returns and investors’ brokerage accounts, the pain gap explains why the behavior gap exists.

A solution to your pain gap is to become aware of how markets’ long-term returns really work.

The S&P 500 has increased more than 119-fold1 over the last 50 years. One of the most important questions in investing is understanding why so many investors haven’t had a good experience during that time.

They have, in many cases, lost money. Underfunded retirement accounts. Been frustrated. Pessimistic. Disheartened. All around a market that has provided ordinary people the opportunity for extraordinary returns.

Financial advisor Carl Richards once described the behavior gap — the gap between stock market returns, and returns that accrue to investors’ accounts after they hurt their performance by buying higher and selling lower.

There is another gap that can help explain the difference between the market’s performance and what investors get from that market performance.

I call it the pain gap.

It’s the gap between what the stock market returns in a given year, and the market’s highest and lowest close during a given year.

The Investor’s Pain Gap by Decade since 1950

The figure above illustrates the difference between annual returns and the gap between the highest and lowest close for each year—both measures averaged by decade—of the S&P 500 index. The data behind this figure was collected from Standard & Poor’s, analyzed by the author. Please note that the figure above reflects the S&P 500, and is not, nor should it be interpreted to be, illustrative of Betterment’s portfolios or investment options.

What is the pain gap?

It’s a different way to think about volatility. But volatility is one of the hardest things for investors to contextualize.

It’s one thing to tell yourself that volatility is normal and expected. It’s another to wrap your head around the idea that even during the best years there can be a huge gap between what the market gained and what you had to put up with to earn that gain.

Take a specific year: 1998. It was the wild 1990s bull market many people wish would return.The S&P 500 rose 26.7% that year. Excellent. But what you would have had to put up with to earn that excellent return was something else. By July of that year, you would have seen a 22% increase. By August, the index was down 2% on the year. By late September, it was up 10% for the year. Then back to breakeven by early October. Then a big rally, finishing 1998 up 26%.

That is not easy to deal with in real time. It is often painful.

The pain gap explains why the investor’s behavior gap exists.

It is easy for investors to look at history and point out how much money you could have made in the past. “Look at the 1990s, you made so much money every year!” you could say. But this is like pointing out how nice a beach resort looks without thinking about its price of admission. The price of admission of the market’s good returns includes putting up with all the unpredictable up-and-down nonsense that is generally far greater than the average annual returns we tend to look at.

The pain gap helps explain why the behavior gap exists. It’s the reason why investors can become frustrated, and take buy-and-sell actions they later regret, despite a market that has been so generous over the years if you just let it work.

Markets look phenomenal and rewarding when you zoom out, because they are. But people don’t live zoomed out. They live day to day, where even the best of times come with uncertainty, and the constant sting of reminding you that markets require patience and endurance in exchange for what they offer you in returns.

That isn’t pessimistic, and shouldn’t scare anyone.

It’s a reminder of what we should pay attention to as investors.

Compounding takes time, and the only way you can survive as an investor during that time is if you are aware of, and prepared to deal with, the pain gap that serves as the cost of admission to the market’s long-term returns.


1 The compound annual growth rate was calculated using the data of Robert Shiller of Yale University’s Department of Economics and Yahoo Finance, between Jan. 1, 1968 and Dec. 31, 2018. Calculation includes dividend payouts. Please note that the S&P 500 is a market index and that you cannot directly invest in an index.

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