Meir Statman is a professor of finance at Santa Clara University and a visiting professor at Tilburg University in the Netherlands. Statman’s research focuses on behavioral finance. His book, What Investors Really Want, has just been published by McGraw-Hill and can be ordered through the link to the right.
I spoke with Dr. Statman on November 26.
What is the overall message of your book, and what led you to write it?
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 lives 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 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 who do nothing right. It is time to describe investors as normal. Normal investors, like the two of us, often commit cognitive errors and are mislead by emotions, but we do not go out of our way to commit cognitive errors and be mislead by emotions. Instead, we commit cognitive errors and are misled by emotions on our way to what we want.
We want more from our investments than profits equal to risks. We want to nurture hope for riches and banish fear of poverty. We want to win, be number one, 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 to our children when we are gone. And we want to leave nothing for the tax man.
Think, for example, about spending a Sunday morning solving a crossword puzzle. You can describe it as a silly waste of time. After all, the solution to the puzzle would be available a week later in the same newspaper. But crossword puzzles are a joy to people who are drawn to them, attracted by the challenge and delighted when they see all the words neatly arranged in their proper boxes. Even those of us who are not attracted to puzzles understand that there is a challenge in solving puzzles and a joy when puzzles are solved. Now think about investors who enjoy solving the puzzles of stocks and stock markets as others enjoy solving crossword puzzles. Spending time on crossword puzzles or stock market puzzles is “normal smart” when done in moderation and “normal stupid” when done in excess. It is stupid to spend all our days doing crossword puzzles when we need to earn money at work. And it is stupid to spend all our days trading stocks if in the process we diminish the value of our portfolios and deprive our families of necessities.
Moreover, we must expand the domain of finance by linking investments with life. The role of financial advisors does not end with helping investors make the most money. What is the money for? What are investors' goals? How does money help investors achieve their goals and enhance their lives?
One financial advisor told me that in early 2009 about two clients who fired him, a father-in-law and a son-in-law. The advisor spoke to the son-in-law, trying to understand what he did wrong or could have done better. "You've ruined our lives," said the son-in-law. It turned out that the father-in-law promised the son-in-law that he would pay for the education of the grandkids. Now a big chunk of the money was gone as the stock market plunged and so did the education goals for the grandkids and the dreams of their success. The advisor did not serve his clients well because he focused on how to construct their portfolios, neglecting to ask and understand what the money was for.
You devote a chapter in your book to why investors join herds and why bubbles inflate. What do you believe is the underlying psychological reason for that phenomenon?
We learn from others and follow them. We ask for advice from friends and colleagues. We try to gain information from the media. We learn in school. And much of what we learn is useful.
Herd behavior has acquired a bad reputation for good reason, but herd behavior is normal and often very smart. When gazelles in a herd see one of them sprint very fast in one direction, they are likely to follow. That herd behavior probably saves their lives, because it is likely that the gazelle that sprinted saw a lion crouching in the grass nearby.
Herd behavior can help humans as well. When we read in Consumer Reports that its washing machine technicians and its herd of users of washing machines found that one particular model needs fewer repairs than others, we are wise to join the herd and buy that machine. Readers know that they can trust Consumer Reports because its technicians test machines rigorously and have no incentive to bias the results. Moreover, users of machines who complete surveys can tell whether a machine works or needs repair and have no incentive to bias their answers. But what is true for the herds of Consumer Reports is not always true for other herds.
Consider the herds of affinity frauds, where people in a church, synagogue, or country club listen to other members who sing the praises of a Bernard Madoff or his equivalent. They rarely stop to ask themselves important questions. Do the people recommending Madoff have expertise at analyzing Madoff's operations as Consumer Reports' technicians have expertise at analyzing washing machines? Do the people recommending Madoff have financial interests in overlooking red flags over Madoff's head? Is it reasonable to accept a claim that an investment has both high returns and low risk?
My mother would tell a story about a village woman who borrowed a spoon from a neighbor, returning it the following morning along with a teaspoon. "The spoon," she said, "gave birth to the teaspoon." Next she borrowed a cart only to announce the following morning that the cart had died. The lesson of the story was obvious even to a little boy. People who are gullible enough to believe that spoons give birth should not be surprised when carts die. There surely are some investments with high returns and low risks and those who shun them miss lucrative opportunities, but people who shun investments that are too good to be true do not invest with Madoff or his kind.
The same is true for joining bullish herds or bearish ones. Bulls shut their eyes to any bearish information, convinced that they are right. Bears shut their eyes to bullish information, convinced that they are right. Smart investors, relying on science, know that the future, bullish or bearish, is hard to forecast. The hold diversified portfolios.
You cited Consumer Reports as an unbiased information source that can deter stupid herd behavior. What information sources are available in the financial markets that you would say investors should be relying on that are similar to Consumer Reports?
There is much reliable and unbiased information. Scholars, such as university professors, are judged by the scientific rigor of their research and its freedom from bias. Their findings, reported in articles and books, are generally reliable. The media often publishes good reviews of scientific research and its findings. Advisors use that research to educate their investors. This is not to say that all research findings fall neatly into interlocking boxes. There are always puzzling and contradictory findings at the frontier of science, whether the science of medicine or the science of finance. But each finding moves us closer the truth.
It is important for all of us to think as scientists. Consider investing in gold. Weigh the arguments for investing in gold and the arguments against it. Are the arguments logical? Are they supported by evidence? How confident should you be in your conclusion that gold is a superb investment or a lousy one? You might conclude that, on the whole, gold is likely to do well, such that the odds are 55% to 45% in favor of gold. Such conclusion might justify placing some of your portfolio in gold, but not all of it.
The theory of momentum-driven markets underlies a lot of the aspects of technical analysis and investment products like managed futures. How does momentum-based investing relate to your concept of herds and bubbles? How could an investor in a product like managed futures determine if they are part of a smart or a stupid form of herd behavior?
One explanation of momentum is that investors and money managers follow one another as a herd. When they see the price of a stock moving up they buy it, especially if they hear from fellow members of the herd that there are good reasons for the increase in price, such as that Warren Buffett is buying.
Some investors are ignorant of the existence of bubbles but other investors are not only aware of bubbles but also know when they are riding bubbles. Such investors hope to dismount bubbles before they explode. But is that hope realistic? Many investors think that they are smart, able to exploit of cognitive errors and emotions of the stupid people of the herd. But often investors who try to exploit the cognitive errors and emotions of others stumble on their own cognitive errors and emotions.
Can you give me an example of that?
If you felt in the early 1999 that dot-com stocks were in a bubble, you were right. But if you sold those stocks short, you might not have had enough financial and mental fortitude to wait until the bubble burst in early 2000. Some of these investors bailed out in late 1999 at huge losses.
It is dangerous to join herds. It is also dangerous to oppose herds. Advisors and investors must remember that the fact that the market is crazy does not turn us into psychiatrists. We have to be mindful that the market can be crazy in crazy ways.
This is another argument for diversification. I say, “I know that there are bubbles. I know there are herds. But I don't really know how long these bubbles are going to last, or if they really are bubbles. So I hold a diversified portfolio, rather than join one herd or another. I make neither bullish bets nor bearish ones."
By diversified, you also mean passively managed?
Not necessarily. But smart active investors must have good reasons to believe that they can outperform passive investors. Active investors engaged in market timing can easily injure themselves.
Individual investors tend to extrapolate from past market trends. They rush in after the market has gone up, thinking that it will continue to go up. This is typical herd behavior.
In my studies I have found a high positive correlation between past returns and individual investors’ forecasts of future returns. I also found a negative correlation between investors' forecasts of future returns and actual future returns. So generally returns are relatively low after periods when investors forecast high returns and returns are relatively high after period where investors forecast high returns. But the correlation between forecasts of returns and actual returns is weak.
If I had to bet, I would bet against bullishness when investors are bullish and against bearishness when they are bearish. But I would often be wrong if I did so. Often the market continues to go up when investors are bullish, rather than go down. So I don't try to take advantage of herds by betting heavily against them. Instead, I maintain a diversified portfolio.
We have to be modest in front of that large beast that we call the market and know that we are as good at controlling investment markets as we are good at controlling tigers by holding their tails.
You spoke before about those who believe gold may be in a bubble. Others feel that bonds are in a bubble. Is there any other advice you can offer to investors as to how to address the question of whether a particular asset class is in a bubble?
There are bubbles in the market and we see them very clearly in hindsight. We know now not only that the real estate market was in a bubble in 2007, but also that the banking system was about to collapse. But that was not nearly as clear when it mattered, when we could have taken action to act against it. Some people did see the bubble in time, but can we trust them to see the next bubble or refrain from seeing a bubble that does not exist? Remember Henry Kaufman, the Dr. Doom of his time? Kaufman saw interest rates increasing in the late 1970s when others did not. He also saw interest rates increasing into the 1980s when, as it turned out, interest rates decreased.
My advice is not to conclude from the fact that there are bubbles that we are able to tell with precision when bubbles inflate and when they will deflate. Gold might be in a bubble, but I would not short gold in a major way it since I do not have the financial and mental fortitude to sustain such a short position even if, in the end, I turn out to be right.
A lot of people made money in real estate. I might look at them and say, “Gee, if only I had joined them.” But then I say, “You know, there is always a risk in that. A lot of people lost money in real estate as well.” I own my home, but I don't own real estate to rent to other people. I have enough real estate in my portfolio by owning my own home.
At the end of the book you discuss the role of government in guiding investment decisions, and you contrast the libertarian and the paternalistic approaches. What role do you believe government should play, and how should it help investors avoid injurious herd behavior?
The government is a messy compromise among us, the people who elect our government. Some people are libertarians, preferring a government that leaves them alone. Others are paternalists, preferring a government which protects them against themselves as well as against others. The law sometimes leans toward libertarians and sometimes toward paternalists.
Consider suitability regulations. Let’s say I come to my broker and I say that I have a wife and kids to feed. I am unemployed and desperate. All I have is $10,000, which would like to invest in a call option on Apple. Suitability regulations are such that if my broker bought that call option for me I and lost my money, I would be able to sue my broker and would likely win my case. Suitability regulations are tilted heavily toward paternalism, appointing brokers as parents to their investors. Libertarians might object to suitability regulations, but suitability regulations are the law.
How far should the government go in telling us what we can and cannot do? Think about Social Security. Some people say we should privatize it and let people invest however they want. Now let's say that that Social Security was privatized such that people could invest in whatever they want. Suppose that a man placed his entire Social Security money in options on Apple and lost his money. Are we as a society ready to say, “Hey buddy, you made your bed; now you're going to lie in it, even if this bed is the gutter?”
The question is not whether we should have a libertarian society or a paternalistic one, because neither extreme is wise. The question is about the proper balance between the two. Our current balance includes paternalistic Social Security and libertarian lotteries. Government provides both. We are at liberty to lose our lottery money but we are not at liberty to lose our Social Security money.
A lot of investors are “normal stupid.” Financial advisors have a sacred duty to help investors, helping them get what they want, educating them, and guiding them away from cognitive errors and misleading emotions.
Read more articles by Robert Huebscher
