Behavioral finance authority Meir Statman caused something of a stir with his award-winning book, “What Investors Really Want,” published in 2010.
Now, in an interview with ThinkAdvisor, the professor reveals an exclusive peek at his next book, “Finance for Normal People,” due in April from Oxford University Press.
On top of that, Statman offers some stay-calm-and-carry-on advice to financial advisors following Donald Trump’s surprise presidential victory.
In his new book, the Santa Clara University professor focuses on the second – and current – generation of behavioral finance. It defines investors as “normal” people with expressive and emotional wants beyond the utilitarian – money-making – wants as posited in first-generation behavioral finance. That earlier version, rooted in standard finance, interpreted investors as “irrational” people stumbling on cognitive and emotional investing errors and seeking only the benefits of high returns and low risk from their portfolios.
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In contrast, second-gen behavioral portfolio theory guides people to investments that “reflect tradeoffs between high expected returns, low risk, social responsibility and high social status,” Statman writes.
Conceived in the late 1950s, standard finance, aka modern portfolio theory, was established in the “anorexic” era of finance, while second-gen behavioral finance looks for a “muscular fit finance,” according to Statman. In his new book, he shows how applying lessons of second-gen behavioral finance can “reduce ignorance … and increase the ratio of smart to foolish behavior.”
Statman, 69, is recipient of three Baker IMCA Journal awards, three Graham and Dodd awards and a Moskowitz Prize, among numerous other honors.
In our interview, he discusses, among other matters, how behavioral finance insights can help FAs deal with the DOL fiduciary rule and stresses that to many investors, “annuities emit the smell of death.”
Statman speaks about socially responsible investing at the upcoming Defined Contribution Institutional Investment Association’s Academic Forum in New York City on Nov. 30. He is on the investment committee of Loring Ward and consults to Wealthfront and to the U.S. Department of Labor.
Here are highlights from our interview:
THINKADVISOR: What’s your advice to financial advisors about dealing with client portfolio concerns now that Donald Trump is president-elect?
MEIR STATMAN: On a phone call at the end of February 2009 [in the depths of the financial crisis], I tried to calm down advisors, telling them that Obama had assembled an excellent group of economic experts and would help improve the economy and stock markets. They were not receptive. Some clients sold all their stocks. At the beginning of the following month, I had a similar call with clients of these and other advisors. The clients were more levelheaded than the advisors. This is a good lesson for today’s Democrats. The world seems to be coming to an end, but it won’t.
Duly noted. Now, what do investors really want?
Everything. What they want from their investments are the same things they want from life. They want wealth. They want well-being – to feel secure that they won’t be poor. They want the hope of being rich. They want to be true to their values. They want a fair market. They don’t want financial advisors to take advantage of them.
You write that “the main job” of an advisor is to “manage a client’s well-being.” That might be a shock to some FAs.
You want to maximize clients’ wealth, of course; but eventually wealth is just a way station to well-being. As an advisor, you have to be concerned about people’s well-being and listen very carefully to them.
What constitutes second-generation behavioral finance?
In the first generation, we took the notion from standard finance that said what people should only care about is getting high returns and not getting low ones. When we saw people who traded a lot, we described them as irrational. The idea of second-generation behavioral finance is that not everything people do that’s different from the recommendations of standard finance that causes low returns is irrational. It’s perfectly normal.
What else is distinctive about second-generation behavioral finance?
The idea of what you’re going to do with your money. There’s really no clear boundary between the making of money and the spending of money. Think, for instance, about expensive watches: They have the utilitarian benefit of telling time. But they also have expressive and emotional benefits — they’re beautiful and show something about who you are.
Do advisors have a responsibility to coach clients from a behavioral finance perspective?
Sure. But you have to be a patient teacher. If an investment is doing poorly – say, international stocks relative to domestic stocks – the client could say, “Why do you have this loser in my portfolio?” Instead of being defensive and saying: “Didn’t I explain diversification to you? Didn’t I tell you these things will happen?” you can do it in a much gentler way. Know that you’ll have to explain the same thing again and again, and that explaining something in good times is different from explaining it in bad times.
From a behavioral finance viewpoint, how do you think the DOL fiduciary standard rule will affect FAs and clients?
This is a wonderful rule. It essentially outlaws common practices that were very beneficial to advisors but not to their clients. It’s a shame that for the longest time, brokers have acted in ways that do not conform to the fiduciary standard. But if you ask [consumers], “What’s the difference between a broker and an advisor who is governed by the fiduciary standard?” they’ll say, “I think my broker is a fiduciary. He makes recommendations in my best interest.” They just don’t understand the difference.
The DOL rule will change the way annuities are sold. You write that many people are reluctant to annuitize partly because “annuities emit the smell of death.” Please elaborate.
There are a number of reasons why people don’t like annuities. The smell of death comes in because they don’t want to be poor – they want to have income that will sustain them in retirement. But they would also like to be rich. So if you take a million dollars from your defined contribution plan and turn it into an annuity, you give up the chance of upside – you know you’ll have decent income but never more than that. On the other hand, if you keep the money invested, at least you can hope to be rich – rich meaning that you don’t have to ask yourself whether you’ve got enough money to go to a restaurant.
People often stay away from annuities because they come with high fees.
Annuity costs are very high, and that’s a blight on the industry. For many people, just the mention of annuities, especially those with riders and all kinds of extras, [reminds them] of old-style car salesmen: You know they took advantage of you, but you hope they didn’t take advantage by many thousands. Those tricks [with regard to annuities] have to come to an end. You need to make immediate and deferred annuities simple and standardized so that people can make easy comparisons across providers just as they can compare prices of identical televisions.
You write that emotion in investing can be good sometimes – and sometimes not.
Generally, emotion is good. We step away from the edge of a roof because of fear. And regret and pride are very useful emotions. With regret, if you’ve done something in life that had bad consequences, you’ve earned a lesson not to do it again.
What about regret in investing?
If you buy a stock and it goes down, there’s no reason for regret because there’s a lot of randomness to [investing], and any link between your action of buying the stock and its going down is very weak. So, in this case regret is [misplaced], and you should know that the stock didn’t fall because you’re stupid. It went down because the market dropped or something you’re not aware of happened. Be kinder to yourself.
What about the emotion, pride?
There are people who concentrate their portfolio on one asset. If it happens to do really well, they think they’re geniuses, when in all likelihood, they acted very stupidly but were lucky – and that luck redeemed them.