Morningstar Director of Personal Finance Christine Benz talks to professor of behavioural finance Meir Statman about the rational and irrational considerations that drive investors, the most common cognitive errors observed and whether one can beat the market by knowing these behavioural biases. Exploiting other’s irrationality comes at a cost, Professor Statman points out.
Christine Benz: Hi. I'm Christine Benz from Morningstar.com. The growing field of behavioural finance looks at how investors don't always behave in perfectly smart ways. Here to discuss the topic with me is one of the leading lights in the field of behavioural finance, Meir Statman, he is a Professor at Santa Clara University, and he is also the author of a new book called 'What Investors Really Want'.
Meir, thanks so much for being here today.
Meir Statman: Thank you. Good to be with you.
Benz: So let's just get to the meat of the book, we know that investors tend to want the highest possible returns they can earn with the lowest possible risks. But what other things do you find in the book and discuss in the book that investors want and try to express through their investing behaviour?
Statman: Well, investors want of course those high returns, but low risks, and it’s a question of why they do that or why do they believe that they can have it. But obviously they want some more, and that might be just the game of playing the market and especially the thrill of winning that game. But for some investors, it is a matter of being socially responsible and so that matters to them.
For other investors, it is status. When I buy hedge funds and we have a conversation and I mention my hedge funds, you know that I'm a rich man even though I didn't brag about it, and so that matters. For some investors, taxes are a big deal such that they're willing to pay $5,000 to save $4,000 in taxes, because they hate the taxman so much. And for all of us, it is about what the money is for. It is for the children, it is for the family, it is for good causes and charity.
Benz: So certainly there's a lot of great research that points to the fact that investors don't always make wise investing decisions because they are thinking about some of these other considerations, but I guess the key question is how do you combat some of those behaviours? What are some concrete steps that investors can take, knowing that they don't always make wise financial choices because of some of these countervailing forces.
Statman: Investor should begin by knowing what they want. And some of what they want is very reasonable. Socially responsible investors can invest in a socially responsible way without giving up any returns or taking on more risk.
But other things are going to costs them money. For example, the desire to just play the market, they trade a lot, that's because we want to win. We think of buy and hold as being mediocre, for the stupid people. But it is really the smart people who do not trade and people who want to win end up losing. And so to the extent that you can figure out the mistakes you make and take precautions against them you are going to do yourself a great favour.
Benz: So are there questionnaires or how would an investor go about doing that soul searching and saying what are my hot button behavioural issues, what things am I responding to emotionally, how do you do that assessment?
Statman: Well, you do that by reading the book. But really more directly there is a range of cognitive errors that people commit, and it's important for people to know that. For example, mutual fund companies tend to advertise their most successful funds, the ones that have five stars from Morningstar.
Well, investors are left thinking that it's very easy to get a very successful fund. They never advertise their one star funds, and so you have to be aware that because mutual fund companies do that it tilts your view as to the likelihood of success. And so you should tilt it back, and say wait a minute, this cannot happen. Hindsight is another one that is very important to guard the gains. It is very easy for all of us to say that in 2007 we knew for sure that the market is going to be terrible in 2008.
If you actually had people write down in pen what they thought in 2007 at the time you would find that they said maybe it will go down, but then maybe it will not go down until 2009 and so on. But now when we get to be in 2010 they remember only that they knew that the market is going to go down, and that really is hindsight that is speaking. So these are two of more cognitive errors that get in the way.
Benz: If there are these behavioural biases, they could be exploited, and you wouldn't necessarily have to join the herd with an index fund, what's your take on that question?
Statman: Well, index funds are fabulous. Now you say well can I do better than average? Can I perhaps exploit other people's cognitive errors? And the answer to that is probably yes. But the question really is how much does it costs you to exploit the cognitive errors of the others.
Think about somebody who says there are $100 bills some place in the streets, so this is the equivalent of a cognitive error of other people, because they have left it lying down.
Well, but it will probably take you three days to find that one $100 bill, if that. And so you're going to waste too much money looking to exploit other people's cognitive errors, and in the process you're going to really shortchange yourself by getting lower returns.
Benz: So if I'm paying an active manager to pick stocks for me or if I am trading a lot myself, I could undo any advantage that I am hoping to gain by exploiting other people's behavioural biases?
Statman: Precisely. If you can gain an extra percentage point of return by exploiting other people's cognitive errors, and it costs you two percentage points to do so, then you're one percentage point behind.
