Angelica Montagano

September 16, 2021

Decision Making, Factor Investing, Investor Behavior, Index Funds, Active Management

Episode 167: Prof. Hersh Shefrin: Fear, Hope, and the Psychology of Investing

Angelica Montagano

September 16, 2021

Decision Making, Factor Investing, Investor Behavior, Index Funds, Active Management

Hersh Shefrin is the Mario L. Belotti Professor of Finance at Santa Clara University. He is one of the pioneers in the behavioral approach to economics and finance. A 2003 article in the American Economic Review listed him as one of the top fifteen economic theorists to have influenced empirical work. He is the author of seven books and numerous articles about how behavioral ideas impact real world decisions.

In many episodes of this podcast we refer to the psychological component of investing, and today we are very happy to host a global authority on the subject and share an absolute masterclass about behavioural psychology as it relates to our finances and the decisions we make. We welcome Professor Hersh Shefrin to the show, who is the author of many books including the seminal Beyond Greed and Fear, which he wrote in the last 1990s, and still holds much value and relevance in today's climate. Professor Shefrin is kind enough to share some reflections on how his understanding of the themes discussed in the book has evolved since those days and unpacks some great pieces from the book for listeners to digest. We get into some specific and technical questions about investing, looking at pursuing the alpha, momentum, and index funds, before our guest also weighs in with some broader, more philosophical responses to our queries. The conversation covers the psychological needs of investors, expected returns, and of course biases. Listeners can expect to come away with a clearer and more detailed picture of ideas we often reference, so make sure to join us for this incredible exploration with Hersh.

Key Points From This Episode:

The key message about market psychology from Beyond Greed and Fear. [0:03:23.1]
Beyond Greed and Fear's three themes: heuristic-driven bias, framing effects, and inefficient markets. [0:04:39.3]
Reflecting on these themes in a modern context and how our understanding has been refined. [0:12:53.6]
Considering index funds in light of market efficiency frameworks. [0:21:08.3]
Assessing one's ability to pursue the alpha and Professor Shefrin's advice to this end. [0:27:14.1]
Possible reasons for large numbers of active money managers at institutions. [0:30:20.6]
Understanding risk-based asset pricing models and expectations of higher returns when investing in riskier stocks. [0:34:41.8]
The impact of behaviour-based versus risk-based explanations for investors. [0:40:00.2]
Utilizing momentum in a portfolio: Professor Shefrin's explanation of this interesting phenomenon. [0:41:58.6]
Comparing the current trading landscape with the advent of online trading in the '90s. [0:46:25.5]
The addictive potential of stock trading; what we know about the neuroscience. [0:49:02.3]
Unpacking the idea of growth opportunities bias and implicit assumptions about averages. [0:52:14.4]
Weighing the relevance of the mean-variance framework to individual investors. [0:57:48.2]
'Carrying a psychological call option'; why Professor Shefrin's depicts advisors in this way. [0:59:09.3]
Professor Shefrin's perspective on the interchangeability of dividends and capital gains. [1:04:42.9]
The big influence that Professor Shefrin's uncle had on his career! [1:08:53.1]
How Professor Shefrin defines success in his personal life and career. [1:12:12.7]

Read The Transcript:

Let's kick it off with a question about your 2002 book, Beyond Greed and Fear. The book starts with a key message from behavioural finance. Can you start by describing what that key message is?

Key message of the book is that psychological phenomena permeate the entire landscape of finance. Then we focused specifically on market psychology is a phrase we often use. Fear and greed is what market psychology is all about. This book is intended to say that our understanding really now goes well beyond greed and fear as primary determinants. It's important for investors in particular, to understand exactly what we now know, as market psychology from a conceptual perspective.

Your book came out in 2002, I believe. Has anything changed about your message since 2002?

No. We just know more details, but the underlying messages are pretty much the same, as they were at the time. That was a 2002 edition. The book actually came out at the end of 1999. We wound up getting it republished a few times.

One of the things that you do in the book that was really quite amazing for such a large body of work that existed then and it's even bigger now, you organized it into three themes, which makes it a lot easier for someone like me learning about the subject to think about. Can you tell us what the themes are and how behavioural finance treats them differently than standard, or traditional finance does?

The first theme is called heuristic-driven bias. It takes the phrase that's used in the behavioural literature, heuristics and biases, and says, “Look, people are imperfectly rational.” We weren't designed to be perfectly rational. We've come a long way. We do wonderful things. We do have imperfections in the way that we make judgments about the world and we make decisions. We have to rely on workarounds. Those workarounds are called heuristics, a Greek word, meaning discovery. We discover ways to deal with our imperfections and our limitations.

In the course of using these workarounds, that do a decent job, but because they're not a perfect job, they're in some ways, biased. Biases are understood to be predictable deviations from something that's right. It's not that just there's some mistakes or errors, but that the errors have specific directions to them. That's the first thing. Understand that investors in particular, and dealing with risk and uncertainty confront the very complex world and make sense of it by relying on heuristics that by their nature, predispose them to be subject to biases.

Then the second theme, we call framing effects. Framing effects are really complicated when you sort them out, but the general idea is pretty straightforward. That's, the words that we use to describe a problem, or an issue, or challenge are important. We can't assume that people will be able to be immune from influence about the way that they either describe issues for themselves, or have those issues described to them.

Any salesperson knows that the words that they use when dealing with the customer are important. That's because customers interpret language and form pictures in their minds. The word framing is a technical word for really, description. We are sensitive to the way that words are used when we hear them and interpret them. The thing about a framing effects is that we react not just unemotionally, although we do when we try and understand what the words mean. We always react emotionally as well. The words that get used, or the pictures that get used, the way issues are described for us, generate some emotional resonance within us, and we respond differently, and our experience is different. That's especially to an investing context, because investing is a very emotional activity. That's the second theme.

Then the third theme is inefficient markets. It used to be the case that investors understood that some stocks are underpriced, some stocks are overpriced. That really smart investors can make a little extra money by discovering which is which, and making investment decisions to capitalize on the fact that markets got things wrong. That was true until the mid-'60s and early 70s, when academics said, “Oh, no. Wait a minute. Actually, markets do a pretty good job at pricing securities.” If we look to see whether we can find evidence of mispricing, we can't. The perspective of the 1970s was that markets got things right. There's a little bit of an overreaction, I think, in academia. Markets weren’t wild and crazy all the time, which is what people thought before the 1960s. Then, they weren't perfectly rational and efficient, which is what academics started to preach in the 1970s.

The point of this third theme is to recognize that markets don't always get it right, and that the impacts of heuristic-driven bias and framing effect on market activity lead prices in some instances to be out of kilter, we’d say inefficient. Those are the real, the overall, the key three themes that describe what behavioural finance is.

How does that differ from the traditional perspective? The working assumption in neoclassical finance, which dominated the field for at least 25 to 30 years was that by and large, investors don't make mistakes, or if they do make mistakes, because of heuristics; the biases are small as the first thing. Merton Miller, who was a very famous neoclassical economist, basically said, of work of behavioural economists, that it’s not that there are interesting stories, there are interesting behavioural stories, but they're a distraction. They're a sideshow. His colleague, Franco Modigliani said the same thing about that work, and both had to say so.

Franco and Merton, I adore them both. They were the complete opposite of the academic spectrum for me. When they made those statements, they were making statements about those were the work that I was doing. That was the perspective that they held. It was not there was inconsequential, but it was a sideshow, and of minor significance. Heuristic-driven bias, yes, maybe, but the biases are small. Framing effects, now, so here's where we really had a difference of opinion, because the Modigliani-Merton perspective named for them, list that framing effects are non-existent. That's really what Modigliani and Merton had as their life's works message to the rest of us, that investors will be able to see through any framing that identify the underlying fundamentals and get the fundamentals right. They won't be misled by framing. That's the second thing.

Then the third thing is that neoclassical economists believe by and large, that the markets are efficient. You have a strong version and a not so strong version. The strong version is that the market provides us with prices that are absolutely right; correspond to intrinsic value. The somewhat weaker version says, markets aren't 100% efficient all of the time. When they get a little inefficient, there's enough smart money. Always on the lookout to make a buck, that those small inefficiencies will get identified and then exploited by arbitrage activity.

Inefficiencies might pop up, but they won't be large, and they won't last long. They'll get arbitraged away. The behavioural perspective is just the opposite. The behavioural perspective is that inefficiencies will pop up on average. You should be surprised if they don't. Moreover, they can get bigger, much bigger before they disappear over time. It can be large and persistent. That's the perspective. If you want to contrast the hidden perspective and the classical perspective from those terms, those three things, that's how I tend to think about the three issues.

Great explanation, all the way through. That was amazing. I love hearing the little – You explained the history of how these theories developed. Hearing you talk about Miller and Modigliani and how they were responding to your work when they're reading their papers, it's like, for me as a relatively recent, I mean, maybe nine years ago now, finance student, yeah, it's just cool to hear you talking about that stuff. Since then, so again, we're talking about this 2002 edition of your book, where you categorized everything into these three – organized everything to these three themes, have any other themes developed since then as the research has grown?

I would say, I think those three things still provide broad categories, but we've refined our understanding of many of them. I'll just give you a couple of directions that have really come along, that provide us with extra insight. I'll start with my own beginnings in the behavioural area. Richard Thaler, we think is the world's most important behavioural economist, he and I were each other's first behavioural collaborators in the 1970s.

The work that we did at the time was to develop a framework that underlies what with Danny Kahneman and his magnificent book called Thinking Fast and Slow. Two systems; one that's instinctive and intuitive, and the other that's – corresponds to conscious thought. Kahneman and Tversky were not actually working with the two-system framework, when they developed the heuristics and biases approach.

Dick Thaler and I, actually, I think, presented the very first formal two-system framework, what we called a two-self model. It was intended to explain why people have self-control difficulties and how they manage self-control difficulties. That particular framework is neurological in nature. It says, we really need to stop thinking about human brains as being monolithic and homogeneous and single entities, but they're really systems where the components interact with each other. The reason that people have self-control difficulties is that sometimes one system is stronger than the other. If the two are in conflict, then you will gravitate between what you think you should do, and what your emotional system says you want to do. Some people say that that's really the very first neuro-economic model that was structured.

Dick and I presented that work to Kahneman and Tversky in 1978. That was well before the field we now called neuro-economics came into being. It was before economists and neuroscientists got together and started to look at what happens from a brain activity perspective, when people make economic and financial decisions. Since that time, neuro-economics has exploded. Now, we understand things that we only had an inkling about in the 1970s and 1980s. We understand the role of dopamine flows. We understand what's going on in the brain when we talk about reward systems. These are neuro reward systems. We know which brain components are activated, the nucleus accumbens. We understand the role that dopamine plays in generating excitement and pleasure. There's a literature that developed in thrill seeking and investing activities. We understand exactly neurologically, what's happening in that respect.

There's a lot of insights that have come from the joint work of economists and neuroscientist, neuro-economists, that really shed great light on an insight into the issues associated with human behaviour. That's one thing that's different. When I talked about the emotional timeline in Beyond Greed and Fear, I had a sense of the fact that investment when you, for example, saving for retirement, investing for retirement, it's not just you invest now, and you wait 30 years and see what happens. You experience a whole series of emotions along the way as events take place.

Those guide how you react along the way, and whether you make decisions, or are passive. That's a very important element that's there. It's not just about making a mean variance choice at time zero, and then waiting until time capital T to see what the outcome is. The other thing that's happened is, I think, is that we now understand that – when Beyond Greed and Fear came out, we understood that – and I started the book by mentioning this. It's not greed and fear that you want to think of as the key issues driving market psychology. They are present, but fear, definitely.

The other key emotion that counterbalances fear isn't greed. It's hope. Greed is a sin. It's one of the deadly sins. Investors are hopeful about what they can do when they have this, but the outcomes are, and that's not a bad thing. It's a bad thing, but hope isn't. Now, hope can be strong. However, there is a third emotion that you do want to couple with those other two, that was made clear to us by a psychologist named Lola Lopes. Her work is just very deep and very insightful.

She said, people are goal setters. People set aspirations. In addition to wanting security to alleviate component we call fear, and in order to deal with potential, we want upside potential to help us meet our need for hope. She said, there's also – people have goals. Those goals involves setting aspirations. Some people set aspirations that are quite high. They attach great importance to achieving those aspirations.

For them, not achieving an aspiration amounts to failure. Success is defined relative to the goals that you set in meeting those goals. People we think of as having very strong drives, be highly competitive, they set high goals, and they attach great importance to achieving those goals. What you find is that if you have really high goals, and it's super important, those are the people that take the biggest risks, because the only way to have a good shot at achieving a very high goal is to take a risk.

It's that perspective, as opposed to the standard deviation return, standard deviation notion, that is underlies what risk means for regular people, especially for investors. The notion that people have wants is that key addition, that was part of the first introductory remarks in Beyond Greed and Fear, and we now know a lot more about that. What we've really seen happen, especially because of the millennial generation now, is that millennials have a much clearer sense of what they want from their investments. It's not just returns. In the mid-'90s, social responsible investing came in. My co-author and colleague, Meir Statman has really been a critical academic in terms of emphasizing the importance of that.

What that work tells us is that investors care about other things besides return. They care where the returns come from. Their own values wind up being expressed in their investment activity. That sits within the emotional response to framing, how issues are described. The description can entail what it is the source of the money, or the way that the money is expressing itself on the economic landscape. I'd say that those are two ways in which the field has changed, but the themes are the same. It's really, that we're having a much richer development of what those themes mean.

Yeah, absolutely. I like to go back to the theme of market efficiency. You talk about how markets can become, or go out of kilter. I'm wondering, based on that, should investors still own index funds, which makes so much sense in the framework of market efficiency?

Yes. At the end of Beyond Greed and Fear, I talk about in the lessons, the takeaways, the lessons for most investors, not all investors, but for most investors, is from a financial wealth generation perspective, act as if mark – invest this if markets are efficient, even though they're not. If you're in it for the long-term, you want to be careful not to outsmart yourself, because there are two counter-balancing forces that work because of behavioural issues.

The first is, markets are not fully efficient. There are theoretical profit opportunities. The second is, you can be the victim of your own behavioural biases. Yes, the biases are stronger than the potential for alpha. You will be sorry in the long run. Most people will be sorry. That's why most investors earn less from a return perspective than the overall markets, because their biases get in the way. It's not as if there isn't theoretical alpha out there waiting to be exploited. Alpha exists as a potential.

You have to be pretty close to neoclassical in your behaviour to actually exploit it over the long run. You have to be willing to take a risk. The message at the end of the book is to understand the following. Number one, most investors should invest as if the efficient market school prescription is right. Don't try and beat the market. Just put together a long-term sensible investing strategy and stick with it along the roller coaster.

Second, what behavioural forces will do, especially heuristics, a heuristic-driven bias? Is it will inject volatility into the market over and above and the mental volatility, the volatility created by fundamentals. Because of that, you have sentiment-based risk, risk associated with changes in sentiment. Sentiment being psychological forces at work, the things that impact us, because of heuristics and bias in particular, but also framing effects, which I can talk about later.

Because of that, it's a wild ride. The best thing is for most investors, from a financial wealth perspective, be willing to experience sentiment-based risk as really not much you can do about it. It's simply the cost you bear for getting a decent return in the long run. If you can accept it, then you can have peace of mind over the long-term in terms of your investment. Now, having said that, I'm going to come back to some of the other things we've learned. We've learned a lot since the publication of the book. I knew that when Beyond Greed and Fear was published, that people had psychological needs from their portfolios, as well as financial needs. I don't think I understood the extent to which they had psychological needs relative to financial needs.

The literature that developed on thrill-seeking behaviour was really insightful. The literature that developed on lottery stocks, the fact that there were certain classes of stocks that have similar features to lottery tickets, and the extent to which individual investors load up on those stocks, I think, that was really insightful. I know when Beyond Greed and Fear was published, I didn't know for example, that in the US, and this is also true in Quebec, in Canada, that the expenditures per household on lottery tickets is really quite significant. Massachusetts, which typically is number one in terms of lottery expenditure per household, the average household, if you take the total number of dollars spent buying lottery tickets in Massachusetts per year, and you divide by the number of households per year, you will get a number over $2,000.

What you'll find is, it's a little bit lower in Quebec, but it's still not insignificant. This tells us just how strong people have a need to take on very high-risk investments, hoping against hope for a huge payoff. The thing is, lottery stocks are – they comprise just under 10% of individual investors’ portfolios. What that means is that there's a very strong need to really have a huge increment in your lifestyle, by taking those kinds of bets.

Lottery stocks are similar to lottery tickets in that their negative net present value projects. When you spend the money, the odds are against you that you're going to – it’s money that you need to be able to afford to lose, because most people are going to lose when they make those kinds of investments. Just that a few of them will wind up benefiting handsomely, because things will pay off. Those are some of the issues that are helping us to understand what the landscape looks like, the three themes are still intact, in terms of the pillars that help organize our thoughts, at least mine. The other elements are really filling in a lot of the details. Those really were not known to me anyway, 20 years ago, when Beyond Greed and Fear came out.

You talked about most investors should probably invest as if the market were efficient, which is something that we've said before, even if it's not perfectly efficient, we should act as if it is. In Bessembinder’s papers that came out on the skewness in individual stock returns, he finished one of the papers by saying something along the lines of, that there are alpha opportunities just based on the skewness and returns, but anybody that thinks they can capture them should review the literature on overconfidence, something to that tune. How do you think someone should decide if they are one of those people that has the skill to pursue alpha?

Set aside a small portion of your portfolio you can afford to lose. I think, it's important for people to understand this system to the rational part really needs to – don't have a few drinks when you think about this. You really want to be clear-headed. Understand what's really important to you. Understand the difference between your long-term financial goals, and the other things you want your portfolio to do for you. We're competitive by nature. More competitive people set higher aspiration levels.

Investing is in part, a social act, because where we sit in the social hierarchy is important to most of us, because we're social animals. A lot of the time, the reason that we buy lottery stocks is because we want to advance socially. Even billionaires compete against each other, not because they're worried about where the next meal is going to come from, but because their goal is to be higher than some other billionaire. These are pretty strong social impulses that we have.

I would say, many, many people simply want to know, and you won't be able to know. There's no test you can take that's a pencil and paper test. You have to actually try it out. You invest in the real sense. You put some money down and you see whether you can – how well you can do in terms of exploiting alpha. It’s just that when you do it, you need to be careful. It's because, if investing is addictive for you, then you may need an AA program for investors, so that you don't get caught up doing something really detrimental to your long run welfare.

If not, just the same way that most people who aren't subject to alcoholic based illness can have a drink or two and be just fine, you can try and see, so the portfolios are satisfying other needs besides financial needs, even though they're tied up with finances. It's important to understand the array of services that I call it the service flow from portfolios. I think, I used that term in Beyond Greed and Fear. I can't remember, but I certainly use that term back in the '90s.

You want to understand the service both from your portfolio and understand that it's not just about wealth creation in a traditional sense. It's also about having a wide array of other needs that get met.

Does that explain why so many institutions continue to hire active money managers? Is there something different that goes on with institutions?

I think, that there are different ways of thinking about it. Institutions are different. I'll take the cynical view for the moment. Again, then I'll move away from that. I just want to do it to get the conversation going. The cynical view is that institutions understand all of this, but are profit maximizing institutions. They're no different from any other sector of the economy.

You make a buck by satisfying customer’s needs. It's possible that you can also help to cultivate those needs, in the same way that tobacco companies encourage young people to smoke, so that they get hooked. Then, you can continue to sell tobacco products for the rest of their lives. If you can get investors hooked on the idea that it's possible to beat the market consistently, that smart investors can do it, that the institutions know how to find the smart investors, and that you can join the club.

Even if you're not smart enough to find the alpha yourself, you're certainly smart enough to find institutions that hire the active managers. Then you'll find, you have a nice business model that feeds investors’ needs to generate positive alpha, and therefore, feel better than average. We know from the overconfidence literature that people do not like to feel they're below average. Everybody wants to be above average. Average is the least that you're willing to put up with is being at average. You simply cater, institutions, cater to those particular needs. That's the absolute cynical view. That is simply a knowing profit basic strategy.

Working in the field, and with active money managers, I think that that's not true of all institutions. I think that there are many people who spend their lives on the active side. They come at it with conviction, that investing is a game of intelligence, just like sports, and that those who are better at it will be able to generate a positive alpha, and they're willing to try. To an extent, behavioural finance says, markets are not efficient. There is something out there to compete about. In theory, it is possible to generate alpha that's positive over the long run and consistently, it's just a question of what the odds are of doing it. There are so many active money managers who are smart people, and have conviction that what they're doing is actually finding alpha. The less cynical, but still somewhat cynical perspective is that those active money managers do, in fact, find positive alpha, on average, but they don't share the rewards with their investors. They charge fees that soak it up.

You do get to say, as an investor who invest with that successful active money manager, “See how smart I am? This is who I use and these are the returns my active money managers created.” You can. You can signal to the rest of the world how smart you are. It's just that it won't show up the value of portfolio, because your fees will be so high. That's the second thing. At least, it's a service. Because this need for social competitiveness is very strong. I'm not saying it's not without value. It has value to investors.

That's the Burke and Greene idea, I think, that the value accrues to the manager that can produce alpha, not to the investors. You're saying that the investors may actually be getting a, I don't know, you call it an externality, a social benefit from investing with that manager. That's unbelievable.

Then active money management is a little bit – I think that having Bessembinder’s point of the positive skewness is true. The positive skewness is what lottery payoffs are about. It also comes together as in terms of conceptual framework.

This conversation is just fascinating. I want to shift gears a little bit to asset pricing. One of the core principles of investing in an efficient market is supposed to be that risk and expected returns are related. Investors need to expect higher returns to invest in riskier assets. You've looked at this and other people have looked at it empirically. Do investors actually expect higher returns from riskier stocks?

No. Just the opposite. They expect safe. They expect safer stocks will actually have higher returns.

What does that tell us about risk-based asset pricing models?

That's a different question in terms of the asset pricing models themselves. One of the most interesting findings from Fama and French's work, when they started to find an integrated perspective to help us understand how the traditional cap and perspective on market premiums, equity premiums, and size and value growth look to market, how those things come together, one of the things they found in their early work was that the coefficients on beta and traditional cap and beta, but in that integrated framework, negative.

Meaning that, in fact, the higher your beta, the lower expected return, everything else being the same. That was a bit of a shock to them. Now, it wasn't strong, but the fact that it wasn't positive going strong, that was pretty surprising. Let's just understand Warren Buffett, one of the most famous investors in the world, has a philosophy that's enabled him to be very successful over the years.

One of the key elements of his investing philosophy is that the stocks he picks are not super exciting. They're low beta. You see, those are the stocks that have the higher excess returns from the negative relationship. Then he uses leverage. This is the same thing that it's – lots of also follows this philosophy that you have an insurance company that generates huge cash flow from premiums, and then basically, you can leverage up your portfolios themselves.

When you follow this particular investing philosophy, you can generate positive alpha over the long term, at least sizeable, consistent return performance. From an asset pricing perspective, it can go the other way, simply because most of the investment community has its upside-down perspective on risk and return.

I'll give you a little bit of history about what I discovered in my own work on this topic. I knew a little bit about it, when I published Beyond Greed and Fear, and I came to understand it a bit more deeply as time went on. In the late '90s, there was a paper by an Israeli economist named [inaudible], that suggested that risk and return appeared to be judged to be have a negative relationship, as opposed to a positive relationship.

I then serve to test that first with my own students, and then with hedge fund managers. I discovered that when you ask the question broadly, what's the relationship between risk and return, if you're thinking in terms of correlation, or the positively correlated, no correlation natively correlated, almost everyone would say, “Well, of course, positively correlated.” Because if you had any experience with textbook finance, that's what they would have learned.

Now, if you then ask them to do specific tasks to evaluate risk and return on individual securities, with security by security, and you get them focused on those local tasks, and then you take their analyses, and you then do the broad perspective, that's when you'll see that their judgments, cross-sectionally suggest that they believe risk and return are negative related. Whether you use data as your measure of risk, or some non-specific general risk variable, call it what you want. Just call it risk on a scale of zero to 10, whatever it is, what you saw was that consistently happened for most investors, and not everyone.

Over about 15 years, every single year, I would do this with a different group of professional investors, not individual investors. In the beginning, I did this with individual investors. What I found was is even true of professional investors. Unless professional investors have some consistency check in their frameworks to see whether they actually are making judgments about risk and return, so that they're positively related the way theory suggests, their natural human psychology will induce them to have to drive it the other way.

You will see in asset pricing models, that those features will come to be reflected. Also, you'll want to be careful, because the behavioural messages don't think it's easy to generate positive alpha by trying to exploit these mistakes. You can see about the investors who shorted Tesla for years. They wound up getting hurt.

For investors who may want higher expected returns as a matter for the value premium, for example, if the explanation is behaviour-based versus risk-based?

No. Not if you simply take the perspective that, I just know that over the long-term, there's actually a decent equity premium. I don't know what extent is behaviourally driven, or fundamentally driven. I'm not smart enough to figure it out. The historical track record tells me that it's a good bet, but it's still a bet. It could go the other way, but it's a good bet to invest as if the market’s efficient, and then just let it run and wait and wait for the returns and why the roller coaster, and don't have the discipline, not to get discouraged in the middle when things look absolutely terrible. The odds are in our favour, that the returns in the long run will be decent.

That's for the equity premium as well as the value premium?

By the equity premium, you mean the fact that stocks earn higher returns than bonds, the government bonds?

Yeah.

Yes. Yes. Yes. The behavioural perspective on the equity premium, what is it? Why do we have such a huge equity premium when theory says, they’re ought to be a lot smaller. Is that markets climb a wall of worries, technician saying, that there is underlying pessimism about stocks that we get so fearful of all the terrible things that happen in the world by reading the news that we think that, “Okay, next year might be fine,” but the long-term prospect, your stocks is really, really terrible.

If that's driving enough investor’s perspective that this is gloomy, then you wind up with a higher premium. It's pessimism, that is the main driver, even though we hear a lot about excessive optimism as being the dominant bias.

What about momentum? I mean, with value and the equity risk premium, there's probably a pretty good behavioural story and probably a pretty good risk-based story with momentum. The story seems to tilt more heavily towards behaviour-based. Does that in any way affect how people should use momentum in their portfolios?

Momentum is a really interesting phenomenon. Historically, momentum came up in the academic literature as a surprise. It came up as a surprise, because the very first behavioural asset pricing paper was the overreaction paper by De Bondt and Thaler. What they argued was that you get reversals, that investing winners, you'll wind up losing money on average, because winners get overpriced. If you're going to buy losers, the losers will revert back, and so you'll earn better returns through that perspective.

If anything, short past winners go along and past losers. Then, along came the story that said, well a lot depends on how you define winners and losers. If you define winners and losers by past 36-month performance, you will get the De Bondt-Thaler effect. If you go based on past six-month performance, it will go the other way. Oh, my God. All of a sudden, we had an April story that was turned upside down. We didn't have an explanation for initially.

The argument meant, well, maybe there's short-term under-reaction, that the reason that you have momentum is because investors get hooked on stories to explain what's happening. When news comes along that's inconsistent with the story, they adjust, but not enough. It's an anchoring an adjustment explanation. It just takes some time to learn. What you see is that you get drift, either positive, or negative as investors slowly adapt, not quickly adapt as in the efficient market version. Slowly adapt to the news.

Maybe that's part of the story. I think, the most interesting story is a story that ties back to framing effects. Here's the way that story goes. If you have a stock that had been doing well, and so a lot of investors have paper gains. Then what happens is that news comes along that is positive. Then what you’ll have happen is that the market will not fully react to the good news for the stock that has lots of paper gains, because of the disposition effect. A lot of, especially individual investors, will start to sell their paper gains to realize them, because they want to feel good, and they worried that the paper gains will disappear.

That will reach hard the adjustment to reflect the full information. What you have is you have a framing effect giving rise to momentum. It's not so much that investors are under-reacting from a heuristic-driven bias perspective. It’s the fact that their psychological needs are being met because they want to feel a sense of pride by selling their winners. The reverse is true on the loser side. You wind up with a downward, the story for losers as well.

This is a testable theory, because if you take two stocks that are subject to the same good news events, and one of them doesn't have a lot of paper gains associated with them, and the other does, what you should expect to see is different risk levels. Momentum is what you'll see when the paper gains, and not much momentum when you jump. That, in fact, is what we do see.

I know there are professional investors with a momentum in exactly this way. That they're just not willy-nilly about which momentum stocks they pick. They pick the ones by evaluating with paper gains are, and that's what they put their money. It doesn't make sense to trade on momentum. It's just that you really have to know what you're doing in order to get the job done. It's not as if that information is available, delivered to you in a nice package by Robinhood, or any other trading platform. You really have to do the work in order to do, and that's where professional investors excel.

Speaking of trading, Hersh, can you draw a comparison between this recent phenomenon of commission-free meme stock, GameStop trading that's been going on? Can you compare the current time, current era to the – still in the '90s, when commission, or online trading started back in the '90s? Can you compare these two periods?

Yeah. They're different. They're different in the sense that in the '90s, there really were ideas that were nascent. You could tell decent stories about huge success. The Internet, the information revolution of the '90s felt like the new industrial revolution, and it was sold that way. It was goldrush mentality, in terms of looking for those companies that looked like they were going to be tomorrow's big winners, the gorillas of the industry.

Mary Meeker, who was the Lead Tech Analyst for Morgan Stanley at the time, coined this phrase, the Walmarting of the web, by which she meant that just as Walmart went from being a little set of stores in Arkansas, food stores in Arkansas, to becoming the dominant retail firm in the world, that was going to happen with e-commerce. It was a matter of looking to see, if you could detect what are the small indicators that tell you which of these small e-commerce rooms is going to wind up being the dominant gorilla in the future. Even though there was this gold rush mentality evolved, it was fundamentally based in terms of structure.

With GameStop, and similar meme stocks, there were others psychological needs that are being expressed there. That really has to do with the small guy versus the big guy. It's, “We're going to show you who really has power, since we feel that in the social hierarchy, you don't have much respect for us. It's time that we're going to teach you a collective lesson.” That was a very, very interesting episode, that the whole point was not about generating long-term wealth, or even about, although to some extent is part of the story was in generating very large in day trade returns, but about teaching somebody a lesson from a social hierarchy perspective. Although, you did that by generating a high first-day return for yourself.

You talked briefly earlier about thrill seeking and dopamine and addictiveness. Is stock trading addictive?

Yes, for many. Now, we know this. Here's what we know. We know that the neural pathways associated with rewards, particularly the neural component, called the nucleus accumbens, which when it's activated, makes us feel really good, because of dopamine flow system. It's our major dopamine pathway. Now, we're at a point where we can put investors into functional magnetic resonance imaging machines and see what's happening in their brain when they're trading. This is what we've learned. We've learned that when you invest in a security that's experiencing a bubble, your reward system during the bubble will soar and you will feel fabulous.

That same expression of dopamine, and those same kinds of feelings are what happens early on to people who wind up with opioid addictions, that you wind up in really craving that the dopamine flow inside your brain, whether it's created synthetically, or naturally. Now, they're not exactly the same, because with opioid addiction, what does happen is that synthetic opioids do wind up creating deterioration and your brain's own ability to produce dopamine, eventually. The dopamine factory winds up being impaired.

Nevertheless, it's true. Once you get hooked on the dopamine flows, there's a downer when it doesn't happen. I think, that investors really enjoy stock market bubbles. It just feels really great. GameStop investors watching what happens. I mean, the sense of euphoria is real. That's very important. Now, I think that that has led the industry to cater to that by using techniques to induce stock market bubbles. The way that it's done is I mean, it's done in a sophisticated way, and it's done not an overtly, but much more overtly.

If you look at security analyst reports, most security analyst reports stay away from doing fundamental analysis. By which, I mean, DCF-based analysis. They'll use fundamental terms, but they will not use discounted cash flow-based valuations. Those that do don't do what textbooks teach. They use inflated DCF. Inflated DCF might apply to a very small minority of firms. They use it in a way that applies across the board for the most part. In the course of doing that, they lead investors to believe that market evaluations when they're frothy, are supported by fundamental value, when that is not the case.

I was going to leave this next question out in the interest of time, but you touched on it just now, so it's worth going there, just with the additional context you just gave. I think, you were talking about – maybe I'm wrong. I think you're talking about the growth opportunities bias that you've written about. If you can talk about briefly what that is, and how it may be related to bubbles and maybe the valuations we're seeing with some types of companies right now.

The idea is, here's what we teach in the classroom. We teach that when you value a company intrinsically by the cash flow it generates, or you expect it to generate, you divide time into two distinct periods. There's the immediate future for the next few years when most companies have a shot, that may not happen, but have a shot at generating returns that are above average, in the sense of the company set some competitive advantage, that allows them to outperform what would happen for most of the market.

Eventually, unless you're protected by patent, or by the military, it's very difficult for companies to have a competitive advantage forever, because smart people come along, and there are always disruptive technologies on the horizon. In the long run, we think that companies, if they survive, will earn about their cost of capital, but nothing more. That just means, they're returning a fair return to their investors, but nothing above and beyond that.

Most kids cannot be above average. Most academics cannot be above average. Most investors cannot be above average. Most companies cannot earn more than their cost of capital. The cost of capital is the average performance for providing compensation for this. Growth opportunities bias is basically, making the assumption that most companies are able to earn more than their cost of capital in the long-term, not just over the next few years. If you make that assumption, you will generate higher value projections down the road than is warranted by a calm, cool, rational view-like perspective.

That, in fact, is what you find in most analyst’s reports, those that do DCF-based cash flow valuation, that the implicitly, not explicitly, implicitly assume that companies will earn more than their cost of capital on average forever, not just in the next few years. Because most of the value of a company, when you do a DCF-based computation, we are talking 60% for the average company, 80% to 90% for a hi-tech company. Most of the value is what happens in the terminal horizon, in the long-term, not the next two, or three or four or five years.

It’s a big number. It's a big contribution. If you get investors hooked on the idea that the market valuations that we're seeing when there's froth are supported by sharp penciled analysts carefully doing their homework behind the scenes to reassure you, the investor, that stocks are fairly priced, then you'll be wind up being misled. That's one thing. I'm just going to add one more thing, okay. This is a sleeper. Most investors and analysts don't go back in time and ask themselves this question. Did the companies we are evaluating, analyzing, actually generate the cash flows we said they would generate 15 years ago, or 10 years ago, or five years ago?

We generate the cash flows we need to support and justify the valuations that were in place back then, because we're making the same assumptions now with the opportunities bias. What you'll find is there are enough companies, not all. That enough companies out there, where the actual cash flows fell far, far short, of the cash flows that were promised or expected, shall we say, back when the valuations were done.

My favourite one is eBay. I like to show a slide, because it's one of my book, Behavioral Corporate Finance. I did a case study in 2000. I wrote it up in 2003, and the book came out in 2005. I just said, “Okay. Well, let's just look over time to see what happened to analysts’ projections.” Now, what I do is I take the initial projections of free cash flows in 2003. I say, “Okay, how do they look in 2010? What were those same teams of analysts from those companies, what were they saying about free cash flows for the company over the next long-term starting in 2010, since 2003? Well, all of a sudden, the curve drops. Go on another five years. As of 2015, what do they say is it going to look like? Drops some more. Another five years, 2020. Down Some more.

The projections just keep on going down for what you're thinking will happen in 2030, and 2040, and 2050. Those are the numbers that we need to come up with how much – how to come up with a fair value for stocks.

Is the mean variance framework relevant to individual investors? This is an important question, I think, because in our podcast listener community, it's a bunch of people – I mean, we're called the Rational Reminder Podcast. A bunch of people trying to be rational investors, and in many cases, thinking about building a better portfolio from a mean variance perspective. Now, Cameron, I don't say that you should do that, but it's what a lot of people who try and think rationally do. Is that framework relevant to individual investors?

The answer is, yes, with a qualification. If you want to build long-term financial wealth, because financial wealth is a primary goal, then mean variance analysis makes a huge amount of sense. Even when markets are not fully efficient. You just have to remember that many investors have other needs that their portfolio satisfy. Mean variance is not the only set of tools that you have to have in place to meet investors’ needs. It's not an engineering problem. It's partly an engineering problem. There's this whole other set of psychological needs that go alongside the strict financial needs. That would be the short answer I can give you.

You refer to having a financial advisor as enabling the investor to “carry a psychological call option.” Can you describe what that means and why that might be helpful to investors?

Yes. We have to remember, investors, among their other needs, are the need to feel smart and the need to advance in the social hierarchy, at least not moved out. If you have a successful investment, you like to have bragging rights about it, so you can show other people how smart you are, either overtly, or – Canadians, I think, are more polite about it than Americans. Everybody has this need to signal something about intelligence and status.

It's nice to be able to take credit. Having the call option means that you basically get to sell the stock. Call option, you sell the stock at the strike price. Your strike price is set way above your purchase price, then bank the game when you sell. That's what it means to have an advisor. Get good advice. Then when the advice pays off, brag about it. There's a put option, too. Then put option is that on the other side, when things go bad, investors really hate to feel stupid. People hate to feel stupid, so investors or people, so investors, they feel stupid. It's nice to blame somebody else. If you can find an advisor who's patient, and can help sooth investor egos when things go wrong, and not take it personally.

It's not easy to do when someone blames you. It's not your fault. You've worked really hard. You haven't behaved unethically. You've done your best. I mean, it's just the markets are bad, or the strategy didn't pay off. Value investing. Look like a great thing 10 years ago. All the statistics said from historical perspective, value beats growth. Well, if you’re a strong value investor over the last 10 years, you underperformed.

There's a tendency for some investors who will want to blame their advisors for the fact that his value didn't play out. Advisors can say, “Well, I did my absolute best. I went with what the averages, the historical averages said. It wasn't my fault.” Just remember that part of your advisor fees are dealing with the underlying psychological issues. You have to absorb the psychological loss of being blamed. If you can do it gracefully, and soothe your client’s egos, they'll stick with you.

It won't be because of psychological performance. One of the most interesting papers in the last couple of years is about the role of robo-advising. Vanguard did this incredible study. They found out what it is that investors are looking for in connection with robo-advising. The thing about robo-advising is that many investors won't do it, though even if it's cheaper. They'll still go with a person. Why? Because the number one need is peace of mind. They don't feel they can get that with a robo-advisor. Even if the advice is sound, even if it's based on the greatest mean variance algorithm, the human touch is still incredibly important. Even for millennials. It's less important for millennials, but it's still important for millennials.

Given all that you know about this field, do you agree with that sentiment? Do you think it's important that people do work with advisors? Or many people do?

Yes. I think, it's important. I'll tell you honestly, I think that it's just like with anything else, it's a question of whether investors get value for money. They can, because we understand that financial planning is a lot harder than it looks. There are certain parts of it that are easy. A lot easier than it's made out to be. Being disciplined during the roller coaster ride is incredibly challenging. It all comes back to self-control issues I studied back in the 1970s. Self-control is hard. Sometimes, we need a partner to help you get through it, so that you don't make a mistake.

You can wipe out half your portfolio wealth by selling at the wrong time during a downturn, and then not getting back in, because you're frozen, like deer in the headlights. A financial advisor can help you make that mistake. When that happens, you will have tremendous value for money as a client, if you've engaged an advisor. Simply, even if even if the actual investment strategy is simple and it looks like you could do it yourself, it's not just what you do with the time to make the decision, the paperwork. There are other biases, status quo bias, that people, instead of actually doing it, they can't get themselves to do the paperwork, or the online version. There's no question that there's potential value from engaging financial advisor to help steer. Then, it’s just a question of whether the advice and the service flow provides value for money with the clients.

All right, I've got one of our last questions here, that's probably a question that we could have spent the whole hour and a few extra minutes talking about. Well, maybe not. Maybe it's a quick answer. Are dividends and capital gains interchangeable?

No. Well, it depends. The answer is, depends who you ask. For some, the answer is yes. For many investors, it's not, especially individual investors. I'll just say, for institutional investors, there were prudent man loss. Dividends can help to support a legal argument in favour of prudent behaviour for an institutional investor.

Even for institutional investors, it's the case that the dividends and capital gains are not interchangeable. For individual investors, there are at least two issues. One is psychologically, a $1 that comes in as a dividend, especially if that piece of the return looks stable and reliable, it gives a feeling of safety. It alleviates the emotion of fear, partly. It generates a psychological benefit.

A capital gain doesn't do that, because it doesn't have that component that triggers that psychological reaction. It's a definite framing effect. The second is that for people who retire, they have developed habits about how to engage in prudent spending of their wealth. During their working years, they got used to relying on their paychecks to support living expenses, and then everything else got put away for the future, or for large purchases.

Well, once labor income, wage and salary income dries up, they no longer have that wealth cash flow coming in, in a way that looks like income. Their old habits work as well, and so they're looking for something that will work with their old habits and dividend income. We call it dividend income. The same with coupons. We call them income. Similar to wage and salary income, and so the same spending rules can be applied to them. It doesn't work for capital gains. With capital gains, you have to worry that once you start to access your liquid assets, it might be like killing the goose that lays the golden egg. You'll overspend and then you'll outlive your assets, because you didn't have a discipline structure in place to deal with the withdrawals. That also comes back to the question of financial advisors. Financial advisors can help you with discipline, once you’re at the withdrawal phase of your investment strategy.

I heard Meir Statman speak at a CFA Wealth Management Conference five years ago, I think. He talked about everything that you just said. Then, he also talked about the problems that come with a dividend focus. Like, you get a lack of diversification. You're probably better off with a more diversified portfolio that doesn't focus on dividends and using something like Monte Carlo to figure out spending. How do you think an investor should think about that tradeoff, where the Miller-Modigliani optimal portfolio doesn't focus on dividends, the psychological one might, how does an investor take those two pieces and decide how to allocate?

You end up in a situation where you definitely need comfort, and you have to understand what the individual's habits are, and how easy it is for a person to change habits. If you change the description of the income, the framing of the way the money comes in, if the description, although on paper, it looks like it's superior, doesn't match with the underlying habits, it's a mismatch, you could do yourself great injury, because you either overspend, or you starve yourself, instead of finding the balance. The answer is going to depend, I think, it'll vary from individual to individual, as to whether you can do it or not. It's not a simple one answer fits all.

Makes sense. Hersh, your work has been very impactful to the field of behavioural finance and finance more generally. Your late uncle was also an important economist, who did a lot of great things for the world. Can you tell us a little bit about him, his work and his influences on you?

You were so kind to ask me. Thank you. My late uncle, Frank Shefrin, he was my father's oldest brother. He became an economist, an agricultural economist, and went to work for the federal government in Canada. He worked his whole life, his whole professional life, thinking about how to alleviate world poverty, especially from a food perspective. He asked himself, "Is there enough food in the world to prevent hunger?"

His work, along with the work of others suggested that there really was a lot of food produced and that people were a lot hungrier than they needed to be in the aggregate. Working with the Canadian government, also with the United Nations, he was at the meeting, the UN meeting in Quebec City, in 1946, that established the Food and Agricultural Organization, the FAO, and became an emissary of the Canadian government to every single FAO meeting during his whole entire professional career.

He was president. The most successful UN agency, I think of all time is the World Food Program, which has branches across the world. There's a Canadian WFP and American WFP. The WFP received the Nobel Peace Prize last year, and my uncle unfortunately, died in 1989, but he would have been so proud to see that. At the end of his career, when he retired, said the WFP was the most successful program period.

I’m happy to say that he was one of the co-founders of the WFP. He was a Canadian civil servant, who took up the charge and worked with a few other countries, the US and the Netherlands in particular, and put the WFP together. He handled governance for the WFP. He was a key player during its first 15 years, 16 years, and was the Canadian representative to the body, during that particular time.

He did a lot of good at the world. He was a great influence on me. I think, I became an economist really, because of him. He took an interest in me from the time I was small. He would continually send me materials to read. He went publications, he went courier. I actually thought I was going to be a physicist. That was my goal in life, not to be an economist. He sowed that seed in me, and I did actually did study physics in university, but I found myself falling in love with economics and his suggestion in economics course, while they’re converting over and that is a terrible choice, which way should I go? I’m going to go in the economics route.

He encouraged me, even when I was in graduate school in London, I met Flora. Visited my wife in London as we were studying. He's just a great influence on me. Most importantly, more importantly, was just a great influence on the world. Did a lot of good. Thanks so much for asking me to speak about him.

What a great, great story. Our final question Hersh, especially after a story like that, how do you define success in your life?

It's making the world a better place; globally, if possible, locally, if possible, people around me, my students, my family. Just doing my best to create a little bit more happiness. If possible, happiness from knowledge. If knowledge, behavioural knowledge. For me, that's what success is about.

Well, you certainly shared a lot of knowledge with us. This has been an amazing, almost hour and a half. Thank you so much for your time. This has been great.

My pleasure, Cameron, thanks so much for inviting me.