Investors Trade Returns for Prestige

Last Updated Dec 13, 2010 12:12 PM EST

In his latest book What Investors Really Want, Meir Statman exposes many of the costly errors we make as investors. One of the biggest mistakes we make is to try to get more out of our investments than just returns, seeking the prestige of owning certain types of investments.

Statman explains that: "Investments are like jobs, and their benefits extend beyond money. Investments express parts of our identity, whether that of a trader, a gold accumulator, or a fan of hedge funds... We may not admit it, and we many not even know it, but our actions show that we are willing to pay money for the investment game. This is money we pay in trading commissions, mutual fund fees, and software that promises to tell us where the stock market is headed." He goes on to explain that some invest in hedge funds for the same reasons they buy a Rolex or carry a Gucci bag -- they're expressions of status.

Writing in 1973, John Brooks offered up this: "Exclusivity and secrecy were crucial to hedge funds from the first. It certified one's affluence while attesting to one's astuteness."

Statman explains that hedge funds offer the expressive benefits of status and sophistication and the emotional benefits of pride and respect. He cites the cases of investors who complain when hedge funds lower their minimums. Those expressive benefits explain both why Bernie Madoff was so successful and why high net worth individuals continue to invest in hedge funds despite their lousy performance - they're ego-driven investments, with demand fueled by the desire to be a member of the club.

Statman also explains how many of us seek investments with returns greater than risks (despite the fact that there are no free lunches). He uses as an example the fact that banks sold $7 billion of reverse convertibles in 2008. Reverse convertibles are securities that carry very high yields and seem to promise high returns. But investors often confuse yield and return. That leads them, as it did Snow White, to fail to see the poison inside the shiny apple.

The returns of these securities are linked to the stock prices of individual companies like Intel. And because stocks are much more volatile than investors realize, the high yields still aren't enough to compensate for the risk. Statman cited the case of an 85-year old radiologist who invested $400,000 in reverse convertibles and promptly lost $75,000. The investor said: "I had no idea this could happen."

When you consider specific investments, ask yourself why you're buying it. If your honest answer has anything to do with the prestige of owning it, you should run away.

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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.