Meir Statman is, in the words of Arnold S. Wood, “an academic detective.” From his perch as the Glenn Klimek Professor of Finance at Santa Clara University, he has helped pioneer the field of behavioral finance and offered compelling insights into what investors really want.
In his latest book Behavioral Finance: The Second Generation from the CFA Institute Research Foundation, Statman opens with a convincing observation: As decision makers, we are not rational, or perennially driven to maximize gains and minimize risk, as standard finance envisioned us. Nor are we irrational, or forever subject to the whims of our behavioral biases and cognitive errors, as the first generation of behavioral finance theorized. Rather, Statman observes, we are simply normal. We are, he writes, “usually normal-knowledgeable and normal-smart but sometimes normal-ignorant or normal-foolish.”
And with that understanding, we have the capacity to recognize when we may fall prey to cognitive errors and biases and correct course en route to achieving our wants.
For more insight on the second generation of behavioral finance, how it can inform our understanding of artificial intelligence (AI) and environmental, social, and governance (ESG) investing, as well as our response to the recent coronavirus epidemic, among other topics, I spoke with Statman via email recently.
What follows is a lightly edited transcript of our conversation.
CFA Institute: What was the impetus for writing Behavioral Finance: The Second Generation? Why a second generation?
Meir Statman: We often hear that behavioral finance is nothing more than a collection of stories about irrational people lured by cognitive and emotional errors into foolish behavior; trading too much, failing to realize losses, and fluctuating between greed and fear. We often hear that behavioral finance lacks the unified structure of standard finance. What is your theory of portfolio construction? we are asked. Where is your asset pricing theory? Yet today’s standard finance is no longer unified because wide cracks have opened between the theory that it embraces and the evidence.
The second-generation behavioral finance offers behavioral finance as a unified structure that incorporates parts of standard finance, replaces others, and includes bridges between theory, evidence, and practice. It distinguishes normal wants from cognitive and emotional errors, and offers guidance on using shortcuts and avoiding errors on the way to satisfying wants.
I wrote my book, Behavioral Finance: The Second Generation, to present the second generation of behavioral finance to investment professionals. The book offers knowledge about the behavior of investors, both professionals and amateurs, including wants, shortcuts, and errors; and it offers knowledge about the behavior of markets. Investment professionals can serve investment amateurs by sharing that knowledge with them, transforming them from normal-ignorant to normal-knowledgeable, and from normal-foolish to normal-smart.
The first-generation of behavioral finance, starting in the early 1980s, largely accepted standard finance’s notion of investors’ wants as “rational” wants — mainly high wealth. That first-generation commonly described people as “irrational” — misled by cognitive and emotional errors on their way to their rational wants.
The second-generation of behavioral finance describes investors, and people more generally, as “normal,” neither “rational” nor “irrational.” Normal people, like you and me have normal wants. We want freedom from poverty, prospects for riches, nurturing our children and families, gaining high social status, staying true to our values, and more. We, normal people, use shortcuts, and sometimes commit errors, but we do not go out of our way to commit errors. Instead, we do so on our way to satisfying our wants.
You show how that binary breakdown of rational vs. irrational in financial or any other kind of decision making is not especially helpful and navigate around it by identifying three distinct types of benefits that people look for when they make decisions: utilitarian, expressive, and emotional. How would you describe each of these?
The utilitarian benefits of watches are in showing precise time. You can buy a watch showing precise time for $50, perhaps even less. Yet some watches cost $5,000 even though they show the same time, and some watches cost $50,000 or more.
Rational people care only about utilitarian benefits, and they are immune from cognitive and emotional errors. Rational people never buy $5,000 watches, yet many normal people buy them, because normal people care not only about utilitarian benefits of watches, but also for expressive and emotional benefits.
We want three kinds of benefits — utilitarian, expressive, and emotional — from all products and services, including financial ones. Utilitarian benefits are the answer to the question, “What does something do for me and my pocketbook?” Expressive benefits are the answer to the question, “What does something say about me to others and myself?” Emotional benefits are the answer to the question, “How does something make me feel?”
An ad for Patek Philippe watches shows a handsome man standing next to his equally handsome son in a well-appointed setting and its caption says: “You never actually own a Patek Philippe, you merely look after it for the next generation.” The expressive benefits of owning a Patek Philippe watch include display of refined taste and high social status, and the emotional benefits include contentment and pride. An internet search reveals that prices of Patek Philippe watches range from a few thousand dollars to hundreds of thousands of dollars.
Many ads for financial products and services bear great resemblance to ads for watches, addressing wants for utilitarian, expressive, and emotional benefits. One shows a smiling grandfather standing next to his grandson, and the caption says: “I want my grandson to spend my money.” Another says: “Feel valued, no matter how much you’re worth.”
Where does environmental, social, and governance (ESG) investing fit in all of this? It seems it could fulfill all three types of wants, assuming returns are relatively in line. Should that make us more or less skeptical of ESG?
Environmental, social, and governance (ESG) is a perfect example of our wants for the three kinds of benefits, utilitarian, expressive, and emotional, in an investment product. Indeed, this is why I was drawn to explore ESG (then called socially responsible investing — SRI) in the late 1980s. My first article on the topic, with coauthors, was published in the Financial Analysts Journal in 1993.
ESG investors gain expressive benefits in demonstrating to others and, more important, to themselves that they stay true to their values, whether opposition to environmental degradation, weapons, or excessive executive pay. And ESG investors gain emotional benefits in peace of mind, knowing that they stay true to their values. Moreover, many ESG investors are ready to sacrifice the utilitarian benefits of portions of their returns for these expressive and emotional benefits.
In my 2011 book, What Investors Really Want, I noted that investment professionals are often uncomfortable with the commingling of utilitarian, expressive, and emotional benefits. As one financial adviser said, “Those investors who are interested in social or ethical investing would be ahead if they invested in anything else, including ‘unethical’ companies, and then donate their profits to the charities of their choice.”
I wrote that this adviser’s suggestion makes as much sense to socially responsible investors as a suggestion to Orthodox Jews that they forgo kosher beef for cheaper and perhaps tastier pork and donate the savings to their synagogues. I noted further that advising ESG investors to separate their ESG goals from their financial goals is symptomatic of a more general tendency among investment professionals to separate the utilitarian benefits of investments from their expressive and emotional benefits.
ESG is popular now but I am concerned that this popularity is accompanied by subversion, as its focus has shifted from expressive and emotional benefits to utilitarian benefits alone, just another way to beat the market. My most recent article on the topic, published recently in the Journal of Portfolio Management is “ESG as Waving Banners and as Pulling Plows.” Banner-minded investors want the expressive and emotional benefits of staying true to their values, but they are unwilling to sacrifice any portion of their utilitarian returns for these benefits. More importantly, they do no good, doing nothing to enhance the utilitarian, expressive, and emotional benefits of others. ESG investors who invest in housing for the homeless, however, are plow-minded; they want to do good and are willing to accept lower than market returns for these benefits. More importantly, they do much good, enhancing the utilitarian, expressive, and emotional benefits of others.
The impact of artificial intelligence (AI) on investment management has been a big question over the last several years. What’s your take on it? Are their instances of AI effectively harnessing behavioral finance to build portfolios that better meet client wants or reduce cognitive errors and behavioral biases?
Some amateur and even professional investors see AI as a tool for beating the market. They seem to frame AI as an outsize tennis racket in a game against traders on the other side of the trading net. These traders are likely tripped by framing errors, neglecting to note that traders on the other side can acquire even bigger AI rackets. Indeed, high-frequency traders use huge AI rackets to win their trading games against amateur traders.
AI, however, can help investors protect themselves from their own cognitive and emotional errors. AI can lead investors to pause and contemplate before they proceed. For example, AI can ask an investor about to trade, “Who do you think is the idiot on the other side of your trade?” “What information do you have that is not known by insiders?” AI can also note the amount of capital gains taxes to be paid if an investor proceeds to realizing gains, perhaps dissuading the investor from proceeding, and point out opportunities to realize losses. Similarly, AI can guard against fear when it is magnified into panic by guiding investors to sell their stocks gradually, by dollar-cost averaging, if they feel compelled to sell.
Obviously, the coronavirus epidemic is the shadow hanging over everything these days. How can the insights of behavioral finance inform our response to it?
We are right to fear COVID-19, and we are right to fear stock market volatility and losses. But we should not let fear turn into panic. We can’t set aside our fear of COVID-19, and we can’t set aside our fear of stock market volatility and losses. But we can step away from our fear and examine it with reason.
Reason in the face of COVID-19 calls for applying some simple rules. If you have flu-like symptoms such as a fever, cough, or sore throat, stay home and consult a physician.
Reason in the face of stock market volatility and losses also calls for applying some simple rules: Do not panic. Look for the silver lining. Investment losses, while painful, can be turned into tax deductions in certain circumstances. Tax-loss harvesting typically gets a lot of attention in December, but there are strong arguments for why realizing losses when they occur makes more sense. Finally, don’t make bets on current stock prices being too high or too low. Neither you nor I nor “experts” know when the stock market has reached its bottom.
Do you see any historical parallels that might inform how we respond to this? Is there any market event that you look to for insight on how this will play out?
We use “representativeness” shortcuts when we assess situations by representativeness or similarity. For example, a person who coughs uncontrollably and suffers high fever, is representative of a person infected by COVID-19. But it is not a sure diagnosis. The person might suffer an illness unrelated to COVID-19.
Representativeness shortcuts can easily turn into representativeness errors in settings where much randomness prevails, such as the stock market. Today’s stock market seems representative of the market of early 2009, when a major stock market decline was about to be reversed into a major stock market increase. But today’s stock market might instead be representative of the market in late 1929, when a major stock market decline did not reach its bottom until 1932.
How are you and your students adjusting to the situation? Are you teaching remotely? How have you managed?
My students and I are adjusting well. I am fortunate to have planned my online Investments course long before COVID-19 was on the horizon. The course places side-by-side standard and behavioral investments and investor behavior, combining a standard investments textbook with my Behavioral Finance: The Second Generation.
My syllabus says:
“This course is centered on evidence-based knowledge of investments and investment behavior. It presents side-by-side standard and behavioral investment theory, evidence, and practice. These include analysis of wants and cognitive and emotional shortcuts and errors, portfolios, life cycles of saving and spending, asset pricing, and market efficiency. These also include analysis of financial markets, such as stock exchanges, and securities, such as stocks, bonds, options, and futures.”
Looking ahead, what do you think is the next frontier in behavioral finance? Is there a potential third and fourth generation?
Views on the future of behavioral finance likely vary greatly among financials scholars and practitioners. I see a third generation of behavioral finance as going from financial well-being to life well-being, adding well-being in family, friends, and community; health, both physical and mental; and work and other activities. A fourth generation will take us from life well-being of individuals to life well-being of societies.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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