Meir Statman is the Glenn Klimek Professor of Finance at Santa Clara University. His research focuses on behavioral finance. He attempts to understand how investors and managers make financial decisions and how these decisions are reflected in financial markets. His most recent book is “Behavioral Finance: The Second Generation,” published by the CFA Institute Research Foundation.
Meir received his Ph.D. from Columbia University and his B.A. and M.B.A. from the Hebrew University of Jerusalem.
Meir’s research has been published in the Journal of Finance, the Journal of Financial Economics, the Review of Financial Studies, the Journal of Financial and Quantitative Analysis, the Financial Analysts Journal, the Journal of Portfolio Management, and many other journals. The research has been supported by the National Science Foundation, the CFA Institute Research Foundation, and the Investment Management Consultants Association (IMCA).
Behavioural finance provides a realistic and comprehensive framework for understanding financial markets and decision-making. Incorporating insights from psychology, it enhances our understanding of investor behaviour, market dynamics, and risk management, leading to more effective investment strategies and improved financial outcomes. In this episode, Professor Meir Statman, a renowned expert in finance and behavioural finance, takes us on a journey through the world of maximizing well-being through finance. Professor Statman is a distinguished financial expert and a leading authority in the field of behavioural finance. His groundbreaking research has shaped the understanding of investor behaviour and its impact on financial decision-making. Through his academic contributions and practical insights, Professor Statman has become a trusted guide in navigating the complex intersection of finance and human behaviour. In our conversation, we explore the world of behavioural finance and its connection to efficient markets, the distinction between normal and rational investors, the allure of lottery-like assets, and the downsides of consuming dividends. We unpack the aversion to realizing losses and the debate between dollar-cost averaging and lump-sum investing. We delve into the rising popularity of alternative investment strategies, the influence of status on rational investor behaviour, the role of financial advisors, and much more. Tune in for this enlightening conversation that will not only reshape your understanding of finance but human behaviour too.
Key Points From This Episode:
Defining what behavioural finance is and how it relates to efficient markets. (0:04:37)
How traditional financial economists responded to Professor Statman's early behavioural work and the current state of behavioural finance research. (0:06:12)
The various generations of behavioural finance and how they differ. (0:08:51)
Differences between a normal investor and a rational one. (0:13:10)
What investors really want and why normal investors like lottery-like assets. (0:15:48)
Reasons normal investors have a preference for cash dividends. (0:20:17)
Downsides of consuming dividends and not capital. (0:22:09)
Unpacking why normal investors are averse to realizing losses. (0:25:40)
Dollar-cost averaging versus lump sum investing. (0:27:57)
The popularity of alternative investment strategies to normal investors. (0:31:13)
Insights about the difference between an error and what a person wants. (0:34:49)
The influence of status on rational investor behaviour and whether financial advisors should cater for elevating status. (0:36:37)
Currency hedging, regret, the value of financial literacy, and the distinction between behavioural portfolio theory and traditional mean-variance portfolio theory. (0:40:50)
Applying the market's portfolio theory to behavioural portfolio theory. (0:49:36)
Exploring theories through a CAPM lens and behavioural theory's interpretation of return premiums from factors like size and value. (0:50:51)
The role of financial advisors in correcting behavioural errors of clients. (1:00:16)
Professor Statman's definition of success. (1:09:25)
Read The Transcript:
Ben Felix: This is the Rational Reminder Podcast, a weekly reality check on sensible investing and financial decision-making from two Canadians. We're hosted by me, Benjamin Felix and Cameron Passmore, portfolio managers at PWL Capital.
Cameron Passmore: Welcome to Episode 258. This week, we welcome Professor Meir Statman, and this is an incredible interview. Meir talked about how finance is all about maximizing well-being. He's well-known in our field, and we're so grateful to get a chance to speak with him. Meir is the Glenn Klimek Professor of Finance at Santa Clara University, where his research focuses on behavioural finance. His most recent book, Behavioral Finance: The Second Generation was published by the CFA Institute Research Foundation. Ben, what are your thoughts after this unreal conversation?
Ben Felix: Well, I mean, listen, Meir is one of the founders of behavioural finance. Speaking with him, just because of that was incredible. But I think that his thinking on finance, and the purpose that money serves, all of that is just incredible. One of the things that I found really impactful in the conversation was how he differentiates between errors and wants. That was to me incredible. This is the Rational Reminder Podcast. Well, hey, rationally what you're doing is an error. But Meir's point is, that if someone's making an error, and you tell them that it's an error, listen, normatively, you shouldn't be doing that thing. If the person says, "No, no, this makes me feel good." That can be okay. Then who's to say that it's a bad decision that they're making? I thought that was incredible.
Meir's research has looked at things, like what are investors’ wants and needs and how do we balance those things a ton on cognitive and behavioural errors? But again, then there's that balancing act of what's an error and what's a want. Then we talked a lot about the role of financial advice as a source of education to help people figure out what's an error and what's a want. I thought that was also really interesting.
Anyway, Meir is in the field of finance, and – well, behavioural finance specifically. He's an absolute giant, and he's got papers published all over the place, tons of fantastic papers. Going through his research to prepare for this conversation. That alone was fascinating. But then, as usual, speaking to him about the research was even better, so I don't know. I just think this is a wonderful, wonderful conversation.
Cameron Passmore: His research has been published in the Journal of Finance, the Journal of Financial Economics, the Review of Financial Studies, the Journal of Financial and Quantitative Analysis, the Financial Analysts Journal, and many more. He is a member of the advisory board of a number of journals, including the Journal of Portfolio Management and the Journal of Wealth Management. Again, many more on top of that. Was named one of the 25 most influential people by Investment Advisor. He is a Ph.D. from Columbia University and a BA, and MBA from the Hebrew University of Jerusalem. He mentions his good friend and professional colleague, Hersh Shefrin, he was our guest pass in Episode 167, so if you want to go check that out.
I also want to give a shout-out to Alex for making the kind introduction to Meir to invite him to join us on the podcast. Lastly, if you listen to the audio, you might want to check out YouTube. His artwork behind them is very cool. I thought his setup in his office is very cool. His artwork, you said, it's a really nice setup that he has. He was really fun, great stories, great guy. It was a really fun time.
Ben Felix: It was a fun time, but you know what, it's a conversation. I remember when we talked to Hersh Shefrin, it had a similar impact on me. It just makes you realize how ridiculous it can be to try and think about everything through a rational lens. Meir talks about what do investors really want. Well, they don't want a mean-variance optimal portfolio. They don't necessarily want that. Think about what investors actually want and what role of finance plays in achieving that. I think that's a wonderful way to look at things and it changes your perspective a lot, relative to the kind of rational normative school of thought. Anyway, going on and on here, but this was another very impactful conversation for me personally.
Cameron Passmore: All right. Great setup. With that, let's go to our conversation with Professor Meir Statman.
***
Professor Meir Statman, it is a real pleasure and a privilege to welcome you to the Rational Reminder Podcast.
I'm delighted to be with you.
Excellent. Well, let's kick it off with a foundational question. What is behavioural finance?
Well, behavioural finance is about financial decisions people make and the reflection of those decisions in financial markets.
Is behavioural finance compatible with markets being efficient?
Well, yes, but I must explain what efficient markets mean because that term has become confusing. There are two notions of market efficiency, one that says that prices are always equal to value. In fact, that was the definition that Fama used in 1965, when he wrote a paper in the Financial Analysts Journal. Somehow along the way, market efficiency became a statement that say, mutual fund managers are unable to beat the market, or more generally, that it is hard to beat the market.
Now, prices deviate from value. We know that there are bubbles, for example, that imply prices much higher than value. But that does not mean that it is easy to identify those bubbles ahead of time. Are we in a bubble now, a positive bubble, a negative bubble? I don't know. This is why I behave as if the market is efficient, and in index funds, and I don't try to time the market.
What was the response from traditional financial economists when you started submitting behavioural work back in the 1980s?
Some of it was kind of funny. In 1984, I had an interview with people of another university just to check for my market value, just in case I don't get tenure at Santa Clara. I explained what I'm doing. One of them said, "What are you trying to do? Are you trying to tweak the profession?" Later on, I met one of them who I knew from before, and I was not surprised that I never got an offer for a job from them.
That's incredible. How well adopted do you think behavioural finance is in financial economics today?
Oh, it is really mainstream now. You'll see it at the very top universities. We, that is Hersh Shefrin, my friend, and co-author, and I are incredibly lucky that our first paper on dividends was accepted and published in the Journal of Financial Economics. That was because the referee turned out to be Fischer Black. Fischer Black is a man who is not only renowned for his wonderful contributions to our field, but also one with a very open mind and an innovative one. His review was brief, but so positive that the editor wrote that after a lot of soul-searching, I guess I agree. That was funny, and of course, delightful.
I don't remember where I read it. But in some of your writing, I think you mentioned that some of the editors of the journal said that they wouldn't publish again if that paper was accepted. Did that happen?
Well, that is the story I heard, that a paper in the Journal of Financial Economics. Later on, I met one of the associate editors who said that there was sort of a raucous phone meeting by their associate editors. Some were so upset by the decision to publish that paper that they said that they would not submit other papers to the journal. Yes, it never happened. I think that they calm down. But you know, it tells you that everywhere in life, you need luck in addition to ability.
How was the second generation of behavioural finance different from the first generation?
At the early 80s, we were really focused on the kinds of mistakes people make, those cognitive and emotional errors. In general, that is not entirely true even then. In general, the assumption was still that people want what rational people want, which is just to maximize my wealth. Then, people do things that hurt their wealth, for example, not realizing losses or trading too much. In the second generation of behavioural finance, I say that people have ones that are different from high expected returns, and low risk, and one direct example of that is socially responsible investing or what is known now as ESG. Where people, some people at least are willing to sacrifice wealth, willing to accept lower returns to stay true to their values.
My first paper about socially responsible investing was published in the Financial Analyst Journal exactly 30 years ago in 1993. It was, for me, a way to convey to people here is something that is neither risk nor return. It has to do with people's value. Some people are willing to accept higher risk and lower returns to stay true to their values. Now, you can kind of expand it to all the things that people want, for example, high status. You look at that, and of course, we all know, all of us care about our status. We measure it in different ways. I know that hedge fund managers are much wealthier than I am, but they are not in my comparison group. My comparison group is fellow professors of finance, and so on.
What's the third generation of behavioural finance?
The second-generation kind of expands the domain or expands the range of behavioural finance, beyond making mistakes, that no longer assumes that all people want is to maximize wealth. People want to maximize wealth, but they also want to stay true to their values. The third generation of behavioural finance really broadens the lens of finance, even broader. It says, eventually, what finance is all about is maximizing people's well-being, which is sometimes called happiness, although happiness is too narrow. The question is, what is money for? Money is for well-being, and well-being has many domains. It is family, it is friends, it is work, it is health, it is religion and values, it’s the society.
I wrote a book that is called Finding Well-Being that looks at these domains. The important thing is that finances, money enhances well-being. But more than that, money underlies well-being in all the other domains. You cannot support a family without money, you cannot see a doctor without money, you cannot enrol at a university without money, and so on. Some people who write about those issues of well-being and happiness say things like what is really important, this friendship. Well, that is nice, but friendship is not enough and you need money even for friendship. Because if you're going to go on the subway to visit a friend, you have to pay.
That’s a great explanation. We've already touched on pieces of the answer to the next question, but I think there's more to it, so I still want to ask the question explicitly. What's the difference between a normal investor and a rational one?
So Miller and Modigliani, two well-known founders of standard finance, defined rational investors as people, as investors, who are interested only in maximizing their wealth, so that is one pillar. The second one is that they are indifferent to the form of that wealth. This really is a definition that they use in their exposition of dividends and the argument as to why dividends do not matter. Because they said, if you don't get a cash dividend from my company, you can create what we know now is homemade dividends by selling shares. They are just different in form, but not in substance. Essentially, they said, framing the form doesn't matter. What matters is just the substance, but normal people care about form as well as substance. They are sometimes confused by the form and sometimes they are not necessarily confused by form, but they care about form.
You will have a situation for example, where people do their accounting generally with nominal dollars. If I got 5%, I consider it kind of a 5% raise. Say, it went from 100,000 to 105. Now, even if inflation is just 2%, I still sort of ignore it and don't say, “Well, really, in real terms, my increase in pay is only 3%.” But what happens is that, when inflation spurts as we've had, and it gets to be, say 9%, then people say, "Wait a minute, I just got a 5% raise, but inflation is 9%, so I'm behind." This for example is why the Fed is aiming at a 2% inflation rather than zero inflation, because it is a way to let people kind of feel good. But the raises they get, while in fact, they are penalized in terms of real money that they are earning.
Okay. So we talked about well-being a little bit earlier, but you got a paper that goes through this in detail. What is it that normal investors really want?
Normal investors want things like supporting a family, raising children, finding satisfying work, and while paying work, they want health, they want to be true to their values as I said. What I am implying, or what I think of as the third generation of behavioural finance is really to see people as a whole person and not just their financial well-being. “Do I have enough money for retirement,” for example. But really, life will be. That is at the centre of the third generation of behavioural finance.
If I kind of come back and tie it back to the notion of rational versus normal, rational people just want wealth. Call it financial well-being. They are avoiding all of those errors that can get in the way. Normal people extend beyond just money, and so they do make mistakes, but you have to distinguish mistakes from wants. For example, the example I have is lottery tickets. People in standard finance, don't buy lottery tickets, because it's stupid. That has negative returns. In the first generation of behavioural finance, we said that that is because people are stupid in the way that they don't understand math and statistics. I say, imagine that you're at 7/11, behind somebody about to buy a ticket, and you say, "Listen, you think that the odds of winning a one out of 100 million, in fact, they are one out of 200 million." Will that person then say, "Whoa" now that I know that I will not buy that ticket? Well, of course, that is silly. People buy lottery tickets, because it provides the emotional benefits of hope for the entire week. They are having that expressive benefit that I'm in the game. God knows, somebody is going to win, and why won't it be me.
You have those three kinds of benefits, utilitarian, expressive, and emotional. That is true for normal people both in the second generation and the third generation of behavioural finance.
Does the lottery ticket explanation also explain why normal investors like to have lottery-like assets in their portfolios?
That is right. That is right. Yes. I like to say that people want two things in life. One is to be rich, and the other is not to be poor. For some of us, being rich means being stocked up with wonderful ideas that grow into Google. But for many other people, especially as they get older, and it is too late for them to go to say medical school, it is buying a lottery ticket. Sometimes it is really sad when you see people who in fact risk being poorer than they are by buying too many of those lottery tickets. But I surely can put myself in their shoes, and understand that they really want the chance to be rich. When I talk about rich, I'm not talking about million-dollar rich. That is one of the interesting things, is that people who buy lottery tickets, yes, we get those super large prizes exceeding a billion dollars. But in fact, people are looking for prices more in the range of $10,000 to $50,000 enough to renovate the kitchen or finally replace that clunky car and so on. For those of us for whom renovating a kitchen or buying a car is no big deal, that seems like peanuts. But for people who are really strain to pay for such things, this is a big deal.
I'd like to go back to your comments on dividends. What is the explanation for why normal investors have a preference for cash dividends when rational investors should be indifferent?
So one reason is because people want to control their spending. So they know that during this home dividend, they're thinking, perhaps that they can actually sell a few shares, and get that money if they don't get a dividend. But they know that they have imperfect self-control. And so if they give themselves permission to sell 3% of shares to get that homemade dividend, then what they are afraid of is that they're going to, in fact, spend not three, but 10. Because there is a need for vacation, there's something that they want to give to the kids, and so on. For that reason of limited self-control, they let the company, in fact, control them and say you're getting a 3% dividend, not more than that. That is one reason people do that. What people do is keep their money in separate pockets, there is capital, let's say the 401(k), and there is income, the income that I get from my employment.
I transfer money from income to capital when I move it to a 401(k), and then I use a rule that we all know of don't dip into capital, which means don't cash out your 401(k). Those mental accounting structures, and the self-control, and that rule of not dipping into capital, help us control our consumption.
I've got to preface this next question by saying that one of the most exciting parts about reading your writing is that you have an incredible command of traditional finance, and you're able to speak to the behavioural side alongside that, and that just makes it fascinating. So on that point, can you talk about the downsides of consuming from dividends and not touching capital?
Oh, yes. That really is very important. It is better to give with a warm hand than a cold one. Those of us who are successful in life, in fact, are the ones who have a good amount of self-control. That is, it takes self-control to stay home, and study for the exam, when your friends are going out to a party because with good grades, you go to graduate school, you get a good job, you earn a good amount of money, then good-self control, helps you save good chunks of that money, and you end up living comfortably. The problem is that some people, many people get so good at self-control, that they have excessive self-control, and they just don't know when to relax.
Well, when I talk about it, people say, "You are describing my parents." I'm talking to them, and I'm saying, "Look, you worked hard all your life, we are settled. We don't really need your money. You should now enjoy your money. Your rugs at home are worn out, you should replace them. I know it costs money, but then you have that money.” It is really hard for people to break that habit and understand that that is because spending has utilitarian costs, because of course, they diminish your wealth, but they can either increase your expressive and emotional benefits or reduce them.
For me, for example, if I'm compelled to go to a restaurant where dinner costs $300 because, God knows, it has some – they call it chopped liver pâté. It's not just that I lost $300, it is that I feel like an idiot. I have a feeling that a cook is there in the kitchen, pretending to be a chef and laughing at those idiots who are paying those exorbitant prices.
But there are other things that gives me pleasure, for example, giving money to my children, or contributing money to charities, or treating myself. Such that when I take my kids, my family and guests to a restaurant, I'm the one who is paying, I take pride in that. It costs me money, but it brings me much pleasure. There is a problem of people who have too little self-control, and generally, financial advisors are talking about that. But when you talk to financial advisors, and their actual clients, they say, actually, our biggest problem is to convince people who have millions to spend and stop living as if they are poor.
Why are normal investors averse to realizing losses?
It begins with framing. You can hear it in the language, that is we have paper losses, and we have realized losses. For many people, realized losses are the same as real losses. If you have a paper loss, it is not really a loss they would say. Now, economists say, this is stupid. Don't you understand? If you bought a stock for 100, and now it is trading at 50, you have lost $50, whether you have realized that loss or not. Now, the thing is that you open an account, you buy a share for $100, and you put it into this account. If it is now at 50, and you realize that loss, then you close that accounted the loss, you kiss your money goodbye. There is no chance for that stock to go back to $100. That is painful. That is the pain that we know as regret, because now, hindsight is telling you, "God, wasn't it clear that this stock is a loser, and so on." But of course, it was not clear. But now it seems in hindsight to be clear.
Now, rationally speaking, you should realize your losses because you get tax benefits from realizing losses. Whereas, you don't have them in paper losses. But at hindsight, and that pain of regret when you close that mental account at the loss is really real for people. Regret is something that we've all felt. Again, I understand people who are reluctant to realize losses. One of the good things financial advisors do, for example, is to help people realize the losses, they call it “harvest your losses” making it feel as if realizing losses is the equivalent of walking in an orchard and plucking peaches from the tree, rather than realizing losses while you are bent over stinking losses.
Why is dollar cost averaging instead of doing a lump sum investment so persistent when it's well known to be rationally suboptimal?
Well, t comes to the same kinds of principles of regret aversion. Think about it this way. Fear is an emotion that is instantaneous. You see something looks like a snake; you move back. Regret is called a cognitive emotion because you contemplate it ahead of time. That is, you have two job offers, and you're going to take one, which one should you take. And you are concerned that later on, you'll find out that they actually chose the wrong one. Say that you just inherited $100,000 from a favourite uncle.
Now, eventually, you want to have it all in stocks. But if I say, “Why don't you just put the money into the stocks right now? The amount is not so large, that it's going to depress prices.” You say, “I hear you, but if I put in the money today, and the stock prices crash tomorrow, I'll feel stupid I'll have that pain of regret.” By dividing that money into say, 10 chunks of 10,000 each, and investing each on a schedule in the middle of a month, over 10 months, you lessen that pain of regret, because sometimes the price will be lower or sometimes it is going to be higher. It's kind of like a diversification principle. But in this case, it is really designed to minimize your regret. It also, because the schedule is fixed. It also really lessens the likelihood of self-control. After three payments, and if the market has gone down, you said, "Whoa enough of that." By having the rule that you commit yourself to for 10 months, you're going to continue to do that.
That's interesting. It's both a commitment device and a regret diversification tool.
You can actually see that when you think about what we know as reverse dollar cost averaging. Let's say that you've got not $100,000 in cash, but rather stocks that are worth $100,000, and you want them actually in cash. Then, if you're averse to risk, because usually, people say, “I invest in dollar cost averaging because I am not willing to take the risk” but it has nothing to do with risk. You can see that here because if you're really averse to risk, you should sell those stocks right now, and have cash, which is riskless. But that's not what people do because people are afraid that as soon as they sell that stock for $100,000, stock prices will zoom. And they're going to be left holding the bag, feeling regret for having sold them all. If you do it gradually in reverse dollar cost averaging, you reduce the likelihood of regret.
That's a really nice way to explain it from the other direction. What about strategies like covered calls and structured products? Why are those so attractive to normal investors?
Well, they are attractive because of the way they are framed. People hate losses, and they hate the prospect of losses. Let's say that you buy a share, and a broker says to you, “Why don't you do covered calls? Why don't you sell call options against it?” They say, "Look, in fact, I take that from a manual for brokers by gross.” What he says is, “You're going to have in a covered call three sources of profit. First, you still hold the stock, so you'll get dividends, that's one source. Second, you'll get the premium from selling that call, that's another source, and throw it because you're going to write that call with an exercise price higher than the current price. You will have the third one, because if it is called, then let's say, the exercise price is 55, and the stock is at 50. You'll still get that $5 between $50 and $55.”
Then he says, “What you're going to lose are those uncertain things that happen if the price goes beyond 55?” Of course, if you find that the stock price has gone not to 55, but to 75, you're going to again feel like an idiot with regrets. What do people do? People are kind of fooled by this framing of three sources of losses. They don't realize that when they buy a call, somebody is selling that call, and that somebody might not be stupid, that somebody might know something that you don't. It is really, again, rationally speaking, it makes little sense. But behaviourally, normally, it does make sense. This is covered calls.
Structured products, again, structured products are arranged such that they have a floor, you cannot lose, you're sure to get your money back. It goes like, if you put in a thousand dollars, you're sure to get back at least $1,000. On top of that, say half the increase of the S&P 500. Well, what happens is, of course, whoever creates that structured product is doing it by buying a zero-coupon bond and a call option. They, of course, make money off that, and then there are some other things that go, one, it is expensive because of the money that the bank or whoever has created it. Also, using again, the issue of mental account. First, they don't count the dividends. If you were to actually hold the stock, you would get the dividend. Second, if they give you back $1,000 after 10 years, well, the real money that you get is less than $1,000 because inflation even at 2% takes a chunk, and so it is really designed to appeal to people kind of tasty ice cream that is going to settle in your waistline.
We've seen research showing that these things are overpriced by 5%, to 8%. I look at that and it's like, that's objectively a bad thing to buy. Could it actually be justified by their behavioural benefits?
Well, the difference between what is an error and what is a want. Let's say that I am a trusted teacher, and I tell a student, "Listen, you will pay 8% on top of that, on top of what it really is worth. Is it worth it to you?” Now, if they say, "Whoa. Now, I understand that I will never touch them again, then I know that it was an error or ignorance that caused that person to buy them." But if they say, "Well, I'll still do that," just as the person who says, “I'll still buy lottery tickets” then I understand that that is what they want. The pain for them of losing money may be so great that they are willing to pay an extra 8% to avoid that pain. It might not make sense to me, but it makes sense to them.
To me, it makes no sense to buy a Lexus when I can buy an equivalent Toyota. But I don't think that people who buy Lexus are stupid, they just are status-seeking, in ways that I am not. I'm status-seeking in other ways, but not in automobiles. My main car – well, my wife just insisted to get a Subaru Outback for me, but my real car is a 1994 Toyota Camry Station Wagon.
That's awesome. But that definition of the difference between errors and wants, that was incredible. Very, very cool. Why do normal, wealthy people want to invest in hedge funds and private equity despite their questionable benefits to a rational investor?
Well, that comes back to the issue of status-seeking that I described. In fact, one person and advisor who sort of sells or recommends hedge funds and the like told me that when an investor comes to him or say $10 million after he sold his business. If he says, "Well, you can invest it in index funds. Well, the minimum to invest in an index fund might be $3,000." He says, “I don't want to be with those little people, I am now a big shot, I have $10 million, let me have something that is unique to those high ones."
When you buy a hedge fund, and when you tell people, if we have a conversation about investments, so you're not really bragging, you're just telling me that you invest in hedge funds? Well, I immediately know that you are at least moderately rich, without you being so crass as to say, "Hi, I'm Meir and I'm a rich man." People buy hedge funds for the same reason that people buy Lexus, Mercedes Benz, and other luxury cars. Yes, they take you from A to B, but they also tell other people and tell yourself that you're a big shot.
Okay. I want to ask your opinion on a very practical question for us, because we believe in index funds being the most sensible investment for most people. But we also have seen the exact scenario that you just described. Should people in our position be catering to that, to that want for more exotic investments?
Well, my sense of financial advisors that you like me are teachers, first and foremost. It comes back to the difference between error and want. If your client thinks that, in fact, hedge funds are riskless assets with returns that are fabulous, then you can disabuse them of that notion, yet you can teach them. But if they say, in one way or another, that they want to feel special, then what can you do? You do that, you try to minimize the damage in the same way that if you have a client or a prospect, who wants to avoid, say, oil companies in his portfolio. You don't really say, "Look, I'm here to just make you money, and then you can do with it whatever you want." You kind of listen to them and you try to find the solution that is consistent with their values, but it is not too expensive, does not damage their wealth more than can be done.
Really interesting. It's kind of like making sure that they understand the trade-offs and then you can kind of gauge whether it's an error or a want.
Yes, and again, remember, the issue is well-being. What you're trying to do is maximize the well-being of your clients. You do that in a gentle way, and you realize that well-being is different for different people. That is, if a friend told you that he has two offers, one that is job that he's going to hate but makes a lot of money, and one that makes enough and more than enough, but he's going to be happy to get up in the morning and do that work. You're going to say, what you're trying to do with your life? Do you really want a job or you're going to hate it every day just because it pays you more?
You see that people come to different conclusions. Some people go to investment companies where they work like dogs, and make a ton of money, and then say, "Retire and live off that." Other people choose to be, say, professors, or financial advisors, making more than enough money to live on, but not fabulously wealthy, and maximize their well-being this way.
We talked about regret earlier. How do you think normal households should deal with currency hedging in their portfolios from the perspective of regret?
Yes. Well, you know, that is always the case. Let's say that you invest in foreign markets, foreign stocks. The value, your returns in dollars are a function of how much those say, Japanese stocks have gone up in Yen, and what happened to the value of the Yen relative to the American Dollar. Now, generally, those funds do not hedge against currency fluctuations, and that is a good thing. But if you have a situation where the currency fluctuations kind of hurt your returns in dollars, people become sensitive to it. It's really as an issue less for individual investors and more for institutional investors. Lots of institutional investors have gotten into the habit of hedging half of it. So they kind of minimize their regret by having, "Well, I have a bit of this, and a bit of that. I'm happy about it." It said about that, but it kind of cancels out that kind of psychological mind game that we are all subject to. I say, forget it. Just do it in a cheap way, because if you buy Japanese stocks, and then hedge the yen, you will pay extra for the hedging part. It's not worth doing.
Since we know about all these normal, but potentially suboptimal behaviours. What should normal investors do with this found knowledge?
I think that if investors are educated, and by educated, I don't mean financial literacy in the sense that it is usually measured. That is, do you know about compounding? Do you know that when interest rates go up, the value of bonds goes down. But rather, if you know the science of finance, that is if you know the facts, if you know, for example, that more often than not, active mutual funds trail index funds. Therefore, it is wiser to buy index funds. By the way, even if on average, active funds do better than index funds. There's going to be a range. Some of them are going to trail the index by a lot, and some of them are going to beat it by a lot, but you don't know ahead of time, which is going to be.
The nice thing about index funds is that you're going to be always in the middle, always mediocre. But I say, it's better to be mediocre than to be the goat. That is what I do. If people have true financial literacy, such as I described why index funds are superior, then they're going to make wiser decisions, then they're going to, for example, do dollar cost averaging, fine. It's no big deal, fine. Just divide it into 10 chunks, that's not really a big deal. But if you chase the recent trend, and concentrate your portfolio in whatever technology, or health, or whatever, that I think is less than wise.
It sounds like it's another case of understanding the difference between errors and wants.
Yes, that is right. Yes. I think there was a clothing store that said, "An educated customer is our best customer."
I like that a lot. Okay. We've been talking about the behaviour of normal investors as opposed to rational ones. I want to move on to portfolio theory. How is behavioural portfolio theory different from traditional mean-variance portfolio theory?
Here's a story. I met Harry Markowitz in person over 30 years ago at a conference. In fact, I told that story because I spoke at the same conference just a month ago. When we sat down to lunch, I took the opportunity to sit with Harry Markowitz. Of course, we engaged in a conversation. I explained to him what behavioural portfolio theory is all about, by pointing to the food plate that was in front of him, in front of me. I said this, mean-variance portfolios, look at the world from the perspective of the stomach. That is, they know that the steak, and the mashed potatoes, and the broccoli, they're just there, because they are carrying nutrients and vitamins, and so on. Why don't we just put them all in a blender, and then suck it in with a straw. You get the same vitamins, and nutrients, and so on.
Now, what I say is that behavioural portfolios are one where you want your steak hot, you want your mashed potatoes hot, you want your beer cold, and so on. Harry Markowitz understood that immediately. He is a wonderful man. I'm really a very fortunate man to know him. He understood it perfectly. He understands investors. Years later, the two of us, Markowitz, and I, and two of our colleagues wrote a paper that kind of combines mean-variance portfolio with behavioural portfolio theory, such that people keep their money in different mental accounts. There's money for retirement, there's money for education, there's money to leave for the kids. And yet, you can do that in a way that is efficient, in a way that lies on the efficient frontier. This really, again, it all kind of comes back to the issue of well-being that underlies it. That is, how is it that you can help people maximize their well-being?
In fact, I tell a story, kind of apocryphal story about going to an advisor, and he does a Monte Carlo simulation of all my assets and goals. He says, "Meir, I have a wonderful news for you. You have a 90% chance of achieving all your financial goals." I go home to my wife and I say, “I just found out that there's a 10% chance we're going to live in the streets." Compare that to, if the advisor puts my money in those two buckets, one for not being poor, one for being rich. Now, I say to my wife, "I learned that our retirement is going to be secure, we'll have money for car, for fixing the roof, and all of that. On top of that, we have a 20% chance to leave a good chunk of money to the kids." It is the same money, but it feels different because it is framed in those mental accounts that correspond to the particular goals I have. Gold-based investing is really built on behavioural portfolio theory.
I've got to say that food analogy was incredible on many levels, because I think you can even take it a step further and say that the food in the blender is even a little bit more efficient.
Exactly. Yes, you can gulp it up faster. Yeah. Those bits of knowledge that you get along the way kind of come back really in an insightful way. When I was a student at the Hebrew University many, many years ago, there was really a footnote in a book by Samuelson, that something that George Stigler, also a Nobel Prize winner did early on, and he calculated what is the best diet if you want it to be the least expensive one that satisfies all your nutrition needs. All you need is kind of five or six evaporated milk and beans. Of course, you kind of look at it and say, "Well, it may work for pigs. I would like to have some chocolates from time to time." That is, again, you really have to understand people, people like me, people like you. We like to have more than the minimum cost diet.
I must say, Meir, I love your stories. How does the market's portfolio theory get applied to behavioural portfolios?
Kind of coming back to what I just said that is, if a client comes to you as an advisor, just saying that your overall portfolio, a return of whatever, of 10%, or minus 20%. In fact, clients as you know, hate the idea of putting all their money into, say, a global mutual fund. They want to have the equivalent of the steak, the beer, and so on. So that you as an advisor can say, "Well, yes, I know we've lost money on these stocks, but we made money on the international stocks, so the large stocks, or the value stocks” and so on. By having those separate entities, you can kind of in some way comfort investors. Of course, many investors will really zero in on the one that did the worst, and they're going to say, "See, you chose for me that stupid investment that went down and you're an advisor so you should have known that ahead of time, and so on." I know that life of advisors is not perfect either.
How would a portfolio optimized for behavioural portfolio theory, look through something like the CAPM lens?
I don't really know that CAPM enters into it. CAPM is kind of built on mean-variance portfolio theory, and it is a very nice and neat model. This is why we kind of – we professors like to present it to our students. But we've moved away from it, now, we're talking about it. Three factors, four factors, or five factors, God knows what it is. It is really, when people say, "Well, behavioural finance is really nice, and I understand the stories and so on. And my husband and wife behaves this way, blah, blah."
But it does not have the rigour they have of standard finance. I say, “What are you talking about?” Think about mean-variance. Who is actually applying mean variance as mean variance? That is, you put reasonable parameters into an optimizer, and it comes back, and it says, "Put 70% in Russian stocks and the rest in Bitcoin." Whoa. You say, "Okay, no Russian stock." So you have a constraint, and no Russian stocks, and no more than 3% in Bitcoin. Then, eventually, with those iterations, you get what you want in the first place. But now, you can say, "Nobel Prize-winning strategy, blah, blah, blah."
What is the asset pricing model of standard finance? It is no longer the CAPM. It is a mess. It is really – they talk about the factor of Zhu. What I think of as behavioural finance is that it provides a realistic picture of the world of finance, and then it also provides with it a kind of guidance as to how you can increase your well-being the most, by knowledge, and by the guidance of advisors, and by the kind of hand holding. This is why I described financial advisors, as financial physicians, it is not enough that you know the intricacies of covered calls and their stocks, bonds, and the rest of it. You really also have to have the kind of bedside manner that physicians have to really increase people's well-being beyond just increasing their wealth.
That was awesome. I want to repeat part of it back and make sure that I interpreted right. The models of standard finance are messy enough that to evaluate a behavioural portfolio and call it sub-optimal would almost be irrelevant because the models are so messy anyway. Does that make sense?
Yes, that generally makes sense. Now, there are some things that is diversification, that is really part of mean-variance. But actually, diversification and the benefits of diversification were known before mean-variance and so on. That has been with us forever. The issue again is, how to use knowledge for the benefit of investors, clients, and students. This means, knowing not just the facts of finance, that when interest rates go up, the value of bonds go down, but also knowing people.
I always tell the story that I heard years ago from one advisor about a couple that came to him, and they said, "Before you start planning for us, you should know that we have a disabled son, and we have to arrange for resources for him when we are gone." Every family has its points of pain. A good advisor, like a good physician, finds those points of pain, and sometimes people are not saying that. You really have to be kind of, if it does some things that are embarrassing, that you are embarrassed to disclose even to your physician. But when you have a physician that you trust, you do that, and then you create a connection. That is more than maximizing my return.
The same applies here. When clients kind of disclose their points of pain, and I say, if it is comfortable for you, as an advisor, disclose your own. Because then, people are going to be open with you. Because if they think that you're perfect, and they have this problem, they may not share it. But if you tell them that you are imperfect, as well, then they will do that. Also tell them, that is when they come and they say, I'm afraid of the market and all of that. You can begin by saying, "I understand that, because I too am afraid. Here's what I do, that is the knowledge I have is what I have, that you don't have. My service to you is imparting that knowledge.”
Interesting. You mentioned factors, how does behavioural theory interpret the return premiums that come from these factors like size and value?
Initially, when Fama and French introduced their three-factor model, they said that size and book-to-market are in fact proxies for risk? Well, there have been many papers that looked at it and they said, "No, it cannot really be proxies for risk.” Shefrin and I wrote a paper where we made the point and argued that they are really proxies for people's want. So, growth stocks are more prestigious. They're likely to have a Tesla, and they're likely to have Facebook, and they're likely to have all of that rather than General Motors, and Ford, and so on, which are in the value category.
So people prefer, say, large stocks, growth stocks because of the same reason that some people prefer a Lexus to Toyota. That is still likely the case, but you also see that value and size have been dogs for two decades now. I wouldn't put a lot of stock in that either. I'm kind of more inclined to think that there's just too much randomness in it. By the time you find that there's a particular factor that works to distinguish high returns from low returns, this is just the time when it stops working. This is why I really don't have much of a tilt in any direction. Now, I do have a growth fund and a value fund, index funds. But now, it is kind of for historical reasons because the growth fan has a lot of capital gains that I don't want to realize. By having roughly the same amount of growth in value, I have, in fact, the equivalent of a total market portfolio.
Very interesting to hear about your portfolio. How do you think that the typical risk profile questionnaires that financial advisors use can be adapted to improve the behavioural dimension of decisions that we've been talking about?
Well, there are many questionnaires, as you surely know. Some of them kind of claim that they are built on whatever scientific principles. Some of them actually have questions that are not about risk, but they are relevant. For example, they will ask you about, say, they'll tell you a story. Here's a company where you've lost a good chunk of money on their stock, but now they've been reorganized, and they have new management and so on. Would you invest in it?
Well, this really is a question not about risk, but rather of regret. That is, this is a case of, that a dog bit you, and now they're telling you that it is a well-behaved dog. Are you going to trust it or not that or not? You remember the pain of the bite is still with you and all of that. Then there are questions like, you feel confident in your ability to choose stocks. Well, this is about overconfidence, and people who are overconfident are willing to choose risky stuff. Of course, they're going to scream when it goes down. But that is what they do now when they answer the questionnaire. I don't really put too much trust in these. I think that advisors use them mostly to cover the rear end if the client sues.
But having a conversation with a client that highlights those issues of hindsight, and framing, and regret, and risk, that is valuable. You can do that with a questionnaire, or I think, better yet, do it as a conversation with clients to really fit their portfolio to who they are and what they want to do.
You mentioned the role of financial advisors quite a few times. What role do you think they should play in correcting the behavioural errors of clients?
Well, as I said, advisors are like me, they are educators first and foremost. It is really important for them. I was asked, should they explain those cognitive shortcuts and errors. I say, of course, they should. It's not like a physician who knows that the patient has cancer. And he says, "No, no, this is just a slight pain in your stomach." You really have to be mindful, of course, do it gently. For example, hindsight, I always say, always begin by admitting that that is an error that is known to you as well. You are not smarter than your clients, you just know more. Let me explain to you how hindsight is working, how framing is working, how overconfidence is working, and so on. That really is a big part of what advisors do.
Now, how much do you bend to your clients? Well, as I said, if somebody comes and says, "I want to be socially responsible, and this is what it means to me." And answering that, "I'm here to make you money, and then you can do what you want" tells that prospect, this fellow does not really listen to me, it doesn't care about me, he has one solution that he's going to shove down my throat. Actually, I use this analogy a lot. I say, imagine that it's an Orthodox Jew who is facing you. You say, "Listen, pork tastes pretty good, cost less than kosher beef. Why don't you buy and eat pork, and donate the savings to synagogue?" Everybody understands that that is ridiculous.
To somebody who feels that having oil stocks in his portfolio feels like pork in the mouth of an orthodox man, then avoid these. But if you think that you're doing good to the world, by avoiding oil stocks, then an advisor should explain that that is simply not true. And that may take more than a few minutes to explain how markets work and why you do no good by excluding oil from your particular portfolio.
I have great admiration for conscientious advisors. They really have a hard job. I, as a teacher, I really try to educate all my students, every one of them. But sometimes there is somebody who says, you know, “I didn't really learn anything” or something like that. That really is very painful. But I still get paid by the university, not by that student. Of course, advisors, if they don't satisfy a client, the client leaves and there's no more revenue from the client. So you are in a more difficult situation than I am. I describe your work as being sacred work, kind of like a priest, a minister, or rabbi, because you are responsible for their financial well-being and ultimately, life well-being.
Are there other ways that financial advisors like us can use behavioural finance principles to improve our client outcomes?
Well, I don't know that I have much to add beyond that, I think that again, if advisors know that what they're trying to do for the client is enhancing their wellbeing, then they're going to educate them on financial instruments, financial markets, the kinds of wants, and cognitive errors, and emotional errors, and, and so on, then be patient. If I explained something, and I see in the eyes of my students that they didn't get it. I don't say my students are stupid. I say I didn't explain it well, so let me see if I can explain it better.
If you explain to our client, that it's not a good idea to let fear cause you to get rid of all the stocks in your portfolio, and you think that you just did it, and then comes another dip in the market, then the client is calling you again with the same story. Just be patient. Explain it again. Don't say, didn't we just talk about it? Why do you bother me with a question that I already answered? Just be gentle, because people are vulnerable. Because, again, good advisors, good financial advisors are good financial physicians. Good at both knowledge of the facts of finance and how to convey them to their clients.
What do you think puts financial advisors in a position to give well-being advice? Because they're not a therapist, they're financial advisors.
Yes. Well, I think that there's just a need for advisors to change their view of who they are. I spoke at a CFA – probably the one that you attended, a CFA Institute on wealth management. I remember that Charlie Hanuman, who used to organize those conferences, we talked about it because CFAs are resentful of CFPs. Because they say, with our education, we know a whole lot more about hedge funds, and about strategies, and so on. Why is it that people actually prefer CFPs to us?
The answer is, that CFPs at least learn something about behavioural finance, and they learn something about how it is that you can help people knowing people's proclivities and so on, how you can use behavioural finance, in fact, to help them. Now, the CFA degree, of course, includes behavioural finance as a component. But still, some financial advisors behave as if what they really would like to do is to manage a hedge fund. Now, they have to deal with those stupid individual investors. Then, of course, rubs on clients, and they don't like it. What you need really is less of those genius investments and more of good people who can manage investors. Know enough about investments, but then know how to help investors.
So I say, I mean, I know generally about hedge funds, but I don't know the intricacies of hedge funds. Do I need to know that? No, I don't know any more than I need to know exactly how my car goes from engine to transmission, and to the wheels. I just know that somehow, I turn on the engine, and I go, and the same applies to advisors. Advisors need different kinds, different sets of skills.
By the way, those technical skills, robo-advisors do them at much, much lower cost. Realizing losses, they do that. Harvesting losses, they construct portfolios, they do those questionnaires, and so on. If you think that you're competing pie chart against pie chart, you're going to lose. The thing that binds clients to you is the thing that binds patients to physicians.
Yes, I totally agree with you. I asked the question because I can imagine listeners wondering the same thing. But you absolutely delivered an excellent answer. We got two more questions for you, Meir. On the topic we were just talking about, do you think that financial advisors should be pursuing education beyond reading your papers that aligns with becoming wellbeing advisors?
Well, education is a wonderful thing. I, for example, subscribe to ssrn.com, and think that it is reasonably free. I just delight in reading abstracts of new papers, as they come. They kind of say, "Wow, this really is fascinating, and this really expands my knowledge, and this relates to something that I already know.” I think that the advisors can do that. Now, most of the papers are of no interest, just scan them, and I shoved them aside. But there's more than one gem per day that I find and I keep a list of those abstracts, and so on. I think that advisors would do well to subscribe to this and read it. There's a need to kind of learn in an efficient way. You don't have to read the entire paper most of the time and the abstract gives you all you need, then it is much faster.
Final question, Meir. How do you define success in your life?
Well, I think that success is well-being. I know that I am a successful man now because my well-being is much higher than it used to be. I know that I have enough money, such that I can spend it comfortably. I can treat others to dinner and so on. Either because I've reached my aspirations, or because I've tempted down my aspiration sufficiently, that I just let things slide. Sure, lots of people have more money than me. Lots of people publish more papers than I did and wrote more books, and so on. But I'm really happy with what I have, and more than that, I am happy in my ability to help other people. Of course, students in the classroom and readers of my books and articles, but also people who simply have less and have lower well-being, and so we contribute.
My wife and I contribute a good deal of money to charity, and to people who need help. We established an endowment at Santa Clara University to help members of the faculty do their research and teaching, and not worry about whether they're going to have enough funds for it. I just let things slide. There is this joke about that tombstone that says, “Publish but perish anyway”. I say, like all good jokes, it is funny because there's a grain of truth in it. I say, really quoting a friend of mine, 10 years after I'm gone, only my children will remember me. Well, maybe a student or two. I hope more. But I kind of know the difference between what really matters and what does not. I focus on those things that enhance my well-being.
What a beautiful cap to an incredible conversation. Meir, we're so appreciative of you joining us. Thank you so much.
Thank you. I was delighted to speak with the two of you and I look forward to being in touch again.
Thanks, Meir.
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Prof. Meir Statman — https://www.scu.edu/business/finance/faculty/statman/
'Behavioral Efficient Markets' — http://doi.org/10.3905/jpm.2018.44.3.076
'What Is Behavioral Finance?' — https://www.cfainstitute.org/-/media/documents/book/rf-publication/2019/behavioral-finance-the-second-generation.pdf
'Behavioral Finance: The Second Generation' — https://www.cfainstitute.org/-/media/documents/book/rf-publication/2019/behavioral-finance-the-second-generation.pdf
What Investors Really Want — http://doi.org/10.2469/faj.v66.n2.5
Explaining investor preference for cash dividends — http://doi.org/10.1016/0304-405x(84)90025-4
The Disposition to Sell Winners Too Early and Ride Losers Too Long: Theory and Evidence — https://doi.org/10.1111/j.1540-6261.1985.tb05002.x
A Behavioral Framework for Dollar-Cost Averaging — http://doi.org/10.3905/jpm.1995.409537
Behavioral Aspects of the Design and Marketing of Financial Products — http://doi.org/10.2307/3665864
Options and structured products in behavioral portfolios — http://doi.org/10.1016/j.jedc.2012.07.004
Lottery Players/Stock Traders — http://doi.org/10.2469/faj.v58.n1.2506
Hedging Currencies with Hindsight and Regret — http://doi.org/10.3905/joi.2005.517170
Behavioral Portfolio Theory — http://doi.org/10.2307/2676187
Portfolio Optimization with Mental Accounts — https://www.cambridge.org/core/services/aop-cambridge-core/content/view/4B23CFB326982C52014A1BA447FA9244/S0022109010000141a.pdf/portfolio-optimization-with-mental-accounts.pdf
Making Sense of Beta, Size, and Book-to-Market — http://doi.org/10.3905/jpm.1995.409506
Affect in a Behavioral Asset-Pricing Model — http://doi.org/10.2469/faj.v64.n2.8
From Financial Advisers to Well-Being Advisers; Well-Being Advisers — http://doi.org/10.3905/jwm.2023.1.202