Santa Clara University professor Meir Statman, a pioneer of behavioral finance, delivered a presentation at the 64th CFA Institute Annual Conference yesterday on “what investors really want.” The short answer, Statman explained, involves four elements that lead to a multitude of mistakes. These desires are:
1. To get high returns
2. To play and win the beat-the-market game
3. To banish fear, savor hope, and avoid regret
4. To pay no taxes
Contrary to the teachings of conventional finance, Statman contended, investors often fall victim to irrational decision making — specifically, to cognitive errors and misleading emotions that get in the way of what we truly want. Statman told conference delegates that investors must recognize that their emotions are powerful motivators — and that not all investing necessarily flows from knowledge and reason. After we’re done watching a film at the movie theater and the lights come on, Statman told delegates, we recognize that the story was an imaginary tale. Unfortunately, though, some investors behave as though the lights are always off and base decisions on fiction, Statman noted.
Traditional models consider people to be “rational” and computer-like, but Statman argued that “normal” people can be “normal-smart” and “normal-stupid.” For example, investors might be inclined to dismiss without reflection the Capital Asset Pricing Model (CAPM) because asset allocation and diversification failed to protect against large losses during the crisis. But investors who draw this conclusion simply misunderstand the limits of diversification (in Statman’s parlance, such a misconception is “normal-stupid”).
Many investors are tempted to engage in market timing, yet shifting to more active trading seems doomed, Statman argued, based on the evidence that shows that being out of equities even briefly during bull markets can result in substantial underperformance.
Backtesting strategies seemingly confirms investors’ superior insight, but such exercises can be biased by “confirmation errors” that result from unconsciously ignoring unfavorable evidence. Investors should stand guard against making status-seeking or ego-stroking decisions, such as trying to “beat the Street” or investing with an exclusive money manager who turns out to be a fraud (Exhibit A: Bernard Madoff) when investing in a simple index fund would be the most suitable option.
We invest ostensibly for utilitarian benefits, but emotion can trump reason. Statman, who discussed an ad for E*Trade, the online brokerage, which ran at the height of the tech boom, paraphrased the tagline: “Trying to make money isn’t half the fun. No, that’s pretty much it.”
Of course, we all know what happened next.