It?s Valentine?s Day. Should you give your beloved $10 or a rose that costs $10?
Think about it in rational economic terms. What good is the rose anyway? It serves no practical purpose, and she can?t preserve it for long to enjoy its beauty. Slowly but surely, the rose will rot. But a $10 note is different. She can use the $10 to maximize her utility. You do not know her utility function, so leave the choice to her. She may buy a book or a frying pan or put it in her savings account.
If you prefer the $10 over the rose, you would be rational?? but plain stupid! That?s because you overlooked the expressive and emotional benefits of giving a rose. This is how Meir Statman, a well-known expert on behavioral finance, exposed the flaw in utilitarian rationality while addressing an attentive audience of investment professionals at the sold-out continuing education event organized by the?CFA Society of the UK in London on 4 Oct 2012. Due to widespread interest in the event, CFA Institute broadcast it live over the Internet.
Carrying the analogy of the $10 rose into investing, Statman explained that while economic rationality demands that investors only seek utilitarian benefits from investing, focusing solely on risk and return, investors often want expressive and emotional benefits as well.
When we invest in a hedge fund only accessible to high-net-worth individuals, we are not only seeking alpha but also making a statement that we are elite and not the average Joe who invests in ordinary mutual funds. Similarly, when we invest in funds that avoid the ?sin stocks??? alcohol, tobacco, gambling?? we are seeking the expressive and emotional benefit of not putting our money where our heart isn?t. Sometimes, we repeatedly buy and sell stocks for the fun of trading, even if such trading loses us money, sacrificing utilitarian benefits for emotional and expressive benefits.
Statman, who is the author of the popular book, What Investors Really Want, used a mix of narrative, images, data, and amusing video clips to enlighten and entertain his audience. He shared findings from complex quantitative research?? such as those from his paper, ?Portfolio Optimization with Mental Accounts,? which was coauthored with the Nobel Prize-winner Harry Markowitz ? in easy-to-understand terms.
Statman emphasized that it is impossible to separate the utilitarian, expressive, and emotional benefits of investing, and when we ignore the expressive and emotional benefits, we lose useful insights into what investors really want.
Institutional investors may think expressive and emotional benefits are relevant for individual investors but irrelevant for professional investors. But, Statman argued,?professional investors also invest for themselves and may be serving individual investors.
Statman argued that investors are not ?rational??? the computer-like utility-maximizing machines that traditional economic theory assumes us to be ? but ?normal.? As normal investors, we are prone to cognitive errors. We may lack self-control, wrongly frame issues, only seek evidence that proves our ideas, have excessive loss aversion, divide our money into mental accounts, be overconfident in our abilities, or thoughtlessly follow others.
His key point was that investors should learn the science of investing?? logic and empirical evidence?? to overcome cognitive errors and make better investment decisions. He gave the example of Noble Prize-winner John Nash, as depicted in the movie, A Beautiful Mind, in which Nash remained unable to differentiate between reality and his hallucinations until he employed logic and empirical evidence.
Statman believes that because of the large and widespread losses across asset classes in 2008, some investors have lost faith in diversification, which is an integral part of the science of investing. Sharing findings from one of his research papers, Statman asserted that even if returns of assets across markets are increasingly going up and down together because of globalization, diversification will reduce both downside and upside as long as the correlation is not one ? the science of investing holds true.
According to Statman, some who have lost faith in diversification are now trying to time the market, often by making subjective assessments of whether the price-to-earnings ratios of stocks are high or low. He argued that market timing may not be impossible but is very difficult, and he showed findings from his research that support this point.
Elaborating upon cognitive errors, he said that investors wrongly frame trading as a solitary jog in the park when it is really competitive running. He reminded investors that in financial markets, they are trading against the most well-informed and resourceful competitors; their chances of beating the market may only be as good as their chances of winning a 100 meters dash against Usain Bolt.
Professor Statman said that ?good investment professionals are like good physicians,? they take care of their clients???not only of their wealth but also of their well being?? through the science of investing. Like good physicians, these investment professionals ?ask, listen, empathize, educate, prescribe, and treat.?
Statman?s final advice to investors: You are neither rational nor irrational but normal. Learn the science of investing to overcome your cognitive errors to become a smart investor. And when the occasion calls for you to give your beloved a rose, don?t be fooled by utilitarian rationality. Don?t give her a $10 note, give her a rose!
If you missed the live broadcast of this event, you can watch this edited recording.
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