Written by Senior Investment Officer, Peter Eickelberg
Meir Statman serves as a finance professor at Santa Clara University. Affable, funny, and insightful, Statman is a real pleasure to hear speak in person. His expertise in “behavioral finance” assures him a place in the financial conference speaking circuit. My autographed copy of his recent book, What Investors Really Want, examines the conflicting aspirations regarding money we all share, attempts to explain the psychology behind them, and provides advice on how to “make smarter financial decisions.” I hope the following discussion helps interest you enough to seek out this highly recommended read:
“We want profits higher than risks.” Somewhere on a visceral, if not intellectual level we should realize that high uncertainty attends high returns. Nevertheless, some investors want to beat the market. “The market” consists of all trading decisions in aggregate, no matter how diverse the views that drove those trades. Whereas investing passively in an index fund, for example, ensures the average market return minus management costs, to get higher performance you have to take on additional risks such as concentrating in certain companies or sectors, making frequent trades, or even short-selling. Some investors do indeed outperform the market—at least for a time, but many others fail. That is the nature of risk. We must be honest with ourselves about risk when attempting a beat-the-market strategy so that we do not fall under the delusion that higher returns and higher safety can peacefully coexist.
“We want to play, and win.” Why do some investors follow high-risk strategies when they know–or should know–that their chances of beating the market fall somewhere below 50 percent? Have you ever met someone who boasted about all the money he made on Apple or Google or Microsoft, stocks whose historical returns are legendary? Think of how you would feel to have put 10 percent of your money into Google right after the IPO. Winning is great! Even “playing the game,” as Statman calls it, provides an exhilaration that feeds its own momentum. If you hang around with the right (or wrong) people, you can engage in hyped-up conversations about trading that can make people feel alive and powerful, part of something important.
However, every Google has its VA Linux. Not everyone wins. In fact, most stock-picking strategies fail to outperform a low-cost index fund given a long enough period of time. So recognize that the “fun” of investing does not constitute a direct monetary benefit. “Wall Street is still a poor place to look for thrills and Wall Street thrills remain expensive, but we are willing to pay the price,” says Statman. Consider your likely financial benefits rather than only subjective emotional benefits when selecting investments. And as the author points out, realize that investing is not like “playing tennis against a wall” but is more like facing an opponent who trades with an opposite view. Will you compete against your next door neighbor or Goldman Sachs?
Statman discusses how “mental accounting,” can lead to decisions not transparently rational. Research shows that people will spend more freely to purchase luxury items when using a gift card than when using cash even though both represent gifts. We seem to spend money differently depending on how we got it, as well. On average individuals receiving transfer payments (social security, unemployment, etc.) play the lottery more than other groups. And we attach different values to different “buckets” of money. One woman interviewed chose to hold a large cash savings as well as a high-interest credit card balance rather than pay off the card with the savings. The cash represented her “nest egg,” so she didn’t want to touch it. These decisions don’t make perfect sense when we just consider the numbers.
Mental accounting often manifests itself in investors’ preference to spend only dividends and interest from a portfolio, not the proceeds of stock sales (i.e., their capital). In reality, dividends actually reduce the value of companies’ stock when distributed; conversely, cash reinvested into the company’s business can lead to higher stock prices. A rational investor should not care whether cash came from dividends or capital gains except for taxes, and current tax law tends to favor capital gains.
The book’s remaining chapters discuss other concepts like how herding behavior leads to bubbles, how our sometimes inordinate aversion to taxes interferes with selling, and how our desire for status may lead us into sometimes unsuitable investments such as hedge funds. In sum, Statman argues that we cannot–and indeed should not–divorce our emotions from investing. Instead, we should remain aware of how cognitive errors and emotional needs may drive our decisions. Once so armed, we can develop sensible strategies and intelligent diversification that best balance the multiple ways we want to enjoy our wealth: for returns, for pleasure, and for self-expression.