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Friday, 14 January 2011

What Investors Really Want

by Laura Rowley

Must investors be rational to be successful?

This question constitutes the underlying tension between classical economics and behavioral finance. The classical model assumes that what people want from their investments is the highest return relative to risk. Behavioral economists say people act stupidly in how they pursue that goal.

Meir Statman, a finance professor at the Leavey School of Business at Santa Clara University, is calling for a diplomatic truce. In his new book, "What Investors Really Want," Statman argues we don't necessarily have to be rational to be good investors. We just have to be smart.

The financial crisis spotlighted extremes in investor irrationality, and since then we've lost sight of "the normal people in the middle — and of course normal people is who we pretty much all are," Statman says. "We all do stupid things. What we need to do is increase the ratio of smart to stupid behavior and know we are not going to be computers. Investors need to have the introspection to figure out what they really want."

So how should "normal people" approach investing? Start by acknowledging what you actually want your finances to do: What is the money for? What goals are you trying to reach, both practically and philosophically? Statman taps a mountain of statistical data and dozens of compelling anecdotes to identify what investors want: to support our families, educate our kids, stay true to our values. (He includes a moving 12th century letter written by a father to his son that demonstrates the timelessness of these desires.) We want fairness, good advice and protection from fraud. We want the utilitarian benefit of growing our money without inordinate risk.

But at the same time, we want our money to say something to others about our values, tastes and status. One investor may choose a socially responsible mutual fund to signal to himself his conscientiousness; another may discuss his hedge fund investments to demonstrate his status (regardless of the fact that most hedge funds, after fees, don't surpass the returns of index funds).

And that's OK, Statman argues — just be honest about your motivation. "For me, index funds work — but for me, a Honda Accord also works, in the sense that I have a good car at a good price, and index funds have good returns relative to risk," he says. "But I would not fault someone who buys an Acura because he wants more prestige, or a sports car because he likes driving it."

So even if the historical data favors index funds or buy-and-hold strategies, trade stocks if you get pleasure from it, Statman says. Just be smart: If you're going to play the market, set aside a small amount of money for that purpose rather than the entire retirement account.

In addition, Statman explains the common cognitive errors that investors make, material that's been well-covered in other behavioral finance books. Mistakes include confirmation errors, when we search for evidence that confirms our intuition, beliefs and hypotheses, but overlook evidence that refutes them; hindsight errors, "the belief that whatever happened was bound to happen, as if uncertainty and chance were banished from the world"; and framing errors, when we make mistakes because of the way we choose to describe a scenario or decision.

For instance, people who play the market may see themselves as playing tennis against a wall when they should see it as potentially playing against Venus Williams. After all, Goldman Sachs or Warren Buffett may be on the other side of your trade.

Investors can overcome these unrealistic notions with a little honesty. "If you tell yourself you are a genius at picking stocks, get someone to audit your portfolio — and tell you whether you're just counting winners and failing to count losers," Statman advises.

I found the book reassuring; I rarely hear economists or planners admit that financial planning must be done in a giant informational vacuum. For instance, he writes about "the Number" — the amount of money we think we need to retire. Surveys have found two-thirds of people think about the Number at least sometimes, and almost half say that calculating the number is difficult and we don't know where to start.

The real stunner in the survey is not that almost half of us think that calculating the Number is difficult, but that more than half think that it's easy. "Calculating the Number is almost hopelessly difficult... not only because it requires so much information, but also because much of that information is uncertain," including the future return on savings and the rate of inflation, Statman says.

I have the same foggy feeling trying to ballpark college savings, especially when the cost of tuition has outpaced everything else in the U.S. economy except for health care. "We come to think about money in a mechanical fashion — what is the number?" Statman says. "And then we realize that life has those zigs and zags, and the biggest risk we face is not that our kid won't be bright enough to go to college or we can't afford it, but God forbid there is a sudden illness or accident — those things that are part of the human condition."

Statman says reflecting on personal experience helps him keep perspective on unpleasant financial surprises. "My parents are survivors of the Holocaust. When you think about black swans, you tell me, what do I do as a teenager when the Nazis are invading Poland? Tell me which market I can hedge?" he says. "The market we can hedge is the market of resilience. So I made a promise to myself always to remember that. If my parents made it through Siberia and Uzbekistan, and had me in refugee camp in Germany, and still managed to raise a family, it really is ungrateful to whine over the loss of a chunk of my portfolio."

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