Behavioral Finance expert Meir Statman has cast his skeptical eye on the world of individual investors and finds we invest just like we shop for a car or sunglasses — some of us are bargain conscious, some are looking for a chance to show off. We can’t have it all, though we think we should be able to, and in this interview with Portfolioist, Statman outlines how that sense of entitlement plays into everything from seeking out the guidance of an advisor to Elizabeth Warren and the push for investor protection. Here are edited excerpts from our interview with the Santa Clara University professor and author of a new book What Investors Really Want:
Portfolioist: What Investors Really Want is your first book for the everyman investor, though your reputation as a leader in the field of behavioral finance is well known in academia and on Wall Street. Why did you decide to write for the general audience now?
I worry that we have moved from the cardboard image of investors as rational to the cardboard image of investors as irrational and lost the true image of normal investors in the process. Normal investors are investors like you and me, often normal-smart but sometimes normal-stupid. I also worry that we have lost the connection between investments and the life of investors beyond investments. I wanted to understand what normal investors really want. And I wanted to describe normal investors as they really are. Because investors who fail to understand themselves cannot help themselves, and advisors who fail to understand normal investors cannot help them.
Standard finance describes investors as computer-like rational people, doing everything right. Much of behavioral finance describes investors as bumbling irrational people doing everything wrong. It is time to describe investors as normal, often right and often wrong.
Normal investors want more from investments than profits equal to risks. We want to nurture hope for riches and banish fear of poverty. We want to win, be #1, and beat the market. We want to feel pride when our investments bring gains and avoid regret when they inflict losses. We want the status conveyed by hedge funds and the virtue conveyed by socially responsible funds. We want financial markets to be fair but we search for an edge that would let us win. We want to leave a legacy for our children when we are gone. And we want to leave nothing for the tax man.
Portfolioist: Your introduction is entitled “What We Want.” It outlines the three benefits of investing, and points out the tradeoffs among them. Can you explain these benefits?
The benefits are utilitarian, expressive, and emotional. Utilitarian benefits are the answer to the question, ‘What does it do for me and my pocketbook?’ The utilitarian benefits of watches include time telling, the utilitarian benefits of restaurants include nutritious calories, and the utilitarian benefits of investments are mostly wealth, enhanced by high investment returns.
Expressive benefits convey to us and to others our values, tastes, and status. They answer the question, ‘What does it say about me to others and to me?’ Private banking expresses status and esteem. A stock picker says, “I am smart, able to pick winning stocks.” An options trader says, “I’m sophisticated, willing to take risk and knowing how to control it.”
Emotional benefits are the answer to the question, ‘How does it make me feel?’ The best tables at prestigious restaurants make us feel proud, insurance policies make us feel safe, lottery tickets and speculative stocks give us hope, and stock trading is exciting.
We face tradeoffs everywhere. A man can take his date to a local Italian restaurant where he would pay $30 for 1,000 utilitarian calories for each of them. Or he can take her to a fancy French restaurant where he would pay $300 for the same 1,000 utilitarian calories plus expressive and emotional benefits. The man gains expressive benefits as he expresses to his date his riches and generosity. He gains the emotional benefits of pride in himself and the hope that this night’s date would lead to more. Sometimes the choice of the expensive restaurant is best. But we must know the tradeoffs between the three kinds of benefits. We can’t have it all.
Portfolioist: Why don’t we know that we can’t have it all?
We want it all in investing, and everywhere in life beyond it. We want to be thin yet enjoy the delicious food that makes us fat. We want to spend everything now and still have it in retirement.
Investors are not always aware of the tradeoffs they face. They tell themselves that they would add to the utilitarian benefits of profits by trading stocks when, in truth, they detract from profits, in exchange for gaining the image of a trader and the pride of occasionally winning.
The financial services industry does not always present the tradeoffs. They regularly imply that we can have it all. They say that we can trade and win. But, more often than not, we can’t.
Portfolioist: Is this a particularly American phenomenon – are other cultures better at understanding tradeoffs and setting realistic goals?
The desire for having it all is common to all people in all cultures. But Americans excel at it. The Dutch know that we are all destined to die and conclude that there is no point in spending billions to add two painful months to the lives of terminal cancer patients. But Americans want to live forever. Our ambition does us good, prompting us to work hard for our high aspirations. And it does us bad when our aspirations are unrealistic.
Portfolioist: You write that hedge funds have the expressive benefit of status and socially responsible fund have the expressive benefit of virtue. We can show the expressive benefits of a BMW or Bentley because people see us driving our cars. But how can we show the expressive benefits of hedge funds or socially responsible funds when others don’t know what’s in our investment portfolios?
Some investments become public in conversation, as when people mention their hedge funds in a conversation about investments at a party. And even if they are not public we feel good when, for example, we stay true to our values by holding socially responsible mutual funds.
Portfolioist: So we buy investments the same way we buy something like sunglasses?
People in both behavioral finance and standard finance see financial products as distinct from other products such as restaurant meals, cars, or sunglasses. I think that’s crazy. We are willing to pay $700 for status sunglasses when other sunglasses with the same utilitarian qualities sell for $50. The same is true for hedge funds, art, or houses.
Portfolioist: You argue that we should not be dogmatic about other people’s investment preferences: that investors should not be berated for trading stocks unless trading costs them money they need for rent or college savings, and that investors in index funds should be more accepting of investors in active funds and vice versa. But isn’t one kind of investing right and the other wrong?
Index funds are right for investors who care only about the utilitarian benefits of high returns relative to risk. But there’s too much self-righteousness in the arguments for indexing. An index fund is like a Honda Accord, a good car at a good price. But a Honda sports car is more exciting, like an active fund. There is nothing wrong in buying a sports car or an active fund unless you imperil your ability to pay rent or save for the college education of your children.
Portfolioist: Can investors learn to distinguish investment truth from investment hype?
I’m a professor, so I must believe that we can find investment truth through science and that investors can learn the truth. But finding the truth and teaching it can be frustrating. We are tempted to believe in what pleases us. (The cheesecake would not add to my waist. I can get high returns with low risk.) And not all trust science. (Don’t tell me that smoking is bad for me. My grandfather smoked like a chimney and lived to 100. Don’t tell me that I cannot beat the market when I know that Warren Buffett beat the market.)
The first step in protecting ourselves from our errors is being aware of our errors. The second is to use science to correct our errors. We must learn to be skeptical of claims of high returns with low risk. Advisors can be very good teachers of science to their clients.
Portfolioist: What about fairness? It’s an idea you’ve spent time thinking about in relation to investing, and it’s at the core of much of the populist anger about the Wall Street bailout and the role financiers played in creating the Great Recession. What do we mean by”fairness” and is investing ever fair?
We mean different things when we speak about fairness. This is why discussions about fairness tend to be like discussions among people who are deaf but not mute. Moreover, we tend to tailor fairness to our self-interest. People who earn $500,000 define rich as earning $1 million. The rich say that taxes are way too high and unfair. The poor say that taxes on the rich are way too low.
Some people in the US believe insiders should be allowed to trade on their inside information and some think it’s unfair, whether legal or not. In the US 70% of college students and 95% of investment professionals say that insider trading is unfair. Percentages are much lower in Italy, India, or Turkey.
In the US more than anywhere else in the world, the stock market has become the symbol of the level playing field, where everyone can become rich through skill and hard work. We are angry when we find that that the stock market is rigged in favor of insiders and the financial system is rigged in favor of bankers. We have little power as individuals to turn the stock market into a level playing field by excluding insiders. But we can protect ourselves against insiders by trading as little as possible.
Portfolioist: What do we need to take into consideration when we think about the proper role of government in regards to fairness or investor protection?
People are arrayed along the line between libertarianism and paternalism. I’m in Elizabeth Warren’s camp, closer to paternalism. I’m concerned that many people would gamble away their Social Security money if Social Security is privatized. Education is insufficient. I’m not ready to say, “Hey buddy, you made your bed; now you’re going to lie in it, even if this bed is the gutter.”