What Investors Really Want
Meir Statman's new book, What Investors Really Want, offers some new insights into the field of behavioral finance. As the writer of the Irrational Investor blog, I can say this book will teach us about our own behavior which acts to meet needs that have nothing to do with risk-return optimization.
Statman is a finance professor at Santa Clara University and one of the leading researchers in the area of behavioral finance. I recently had the opportunity to meet face to face and talk to Statman about his research in this fascinating book.
Investors really want far more than the wealth maximization thought by simple economics. We have two additional needs.
We want to feel good
It is our desire to feel good that can cost us so much in the way of returns. When markets are going up, we feel compelled to participate in the gains in order to feel good. During those bullish times, the tendency is to view risk in theoretical ways, understanding that there is a five percent probability our portfolio could lose thirty percent. However, when a year such as 2008 comes along, our view of risk becomes magnified by a fear we didn't feel earlier when times were good.
So market plunges replace that good feeling with anxiety and despair, which we try to counter by selling every stock that is not nailed down, convincing ourselves that we are acting rationally. I noted that investment flows from stock funds continued more than an year after the recovery, and Statman stated this was due to the vividness of this last market crash which happened much faster than the first plunge of the century.
We want emotional well-being and status
Statman questioned why it is that some people wear a $5,000 Rolex, when the $10 Timex provides the same functionality and accuracy. The obvious answer is that having a status item makes us feel good about ourselves. The same is true of investing.
Statman stated that a hedge fund is the equivalent of the Rolex. Casually mentioning that you are invested in a hedge fund relays the message loud and clear that you belong to a sophisticated, elite class of accredited investors, thereby making you sophisticated and elite. That you were invited to invest in this class of investments that will not be open to the masses, sets you apart and above the Average Joe investor.
Real people - real behaviors
Statman gives many great examples of human behavior that defy traditional economics, but seem to make sense using Statman's non-utilitarian criteria.
- In a study, more women chose a spa package valued at $80 over $85 cash. They responded that they were more likely to spend the $85 on groceries.
- We buy lottery tickets when we know our expected return is half our investment (50 cents for every buck) because we enjoy imagining what it would be like to win.
- We are happier earning five percent with eight percent inflation than we are earning two percent with no inflation because we think in nominal terms.
Having money is the adult version of a security blanket. Money helps us sleep well, knowing we have what we need for a rainy day, particularly if the roof is leaking. Money buys our way out of difficulties and makes us feel worthy. We are less likely to become depressed if we have access to a steady supply of money. And because money has such an influence over us, it's not surprising that we act in non-utilitarian ways.
Irrational investor
In the dark ages of understanding investing, I emerged as a freshly minted Northwestern MBA in 1982, thinking I was a logical being with the investing goal of maximizing my risk-adjusted return. How could I have been so naive?
Today, with the benefit of hindsight, my columns are often about investor behavior that is completely irrational from the perspective of traditional economics. Statman makes it obvious that utilitarian benefits are only one of the three categories of investor needs. When you frame investor behavior around expressive and emotional needs, our behavior is far more logical and predictable.
Meir's book is truly one of the great books on behavioral finance. If you want to learn more about your behavioral traits, and get that counter-productive tiger by the tail, this is a must read. Understanding what drives us is the key to changing our behavior.
My advice is to try to fulfill your expressive and emotional needs outside of investing. Work to maximize utilitarian benefits within your portfolio. It is doing this that will ultimately lead to long-term fulfillment of your expressive and emotional needs.
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