The Evolution of Behavioral Finance ft. Meir Statman [LIVE] (EP.119)

0:28We all need to make smart decisions with our money. the world's largest wealth festival, and my guest was none other than behavioral finance giant Mayer Statman. Mayer's research focuses on understanding how investors and managers make financial decisions and how these decisions are reflected in financial markets. The questions he addresses in his research include, what are investors' wants and how can we help investors balance them? What are investors' cognitive and emotional shortcuts and how can we help them overcome cognitive and emotional errors. How are wants, shortcuts, and errors reflected in the choices of saving, spending, and portfolio construction?

1:09Mayer has been publishing on behavioral finance since the 1980s, before it was even really being called that. And you can find his work in the Journal of Finance, the Journal of Financial Economics, the Review of Financial Studies, the Journal of Financial and Quantitative Analysis, the Financial Analyst Journal, the Journal of Portfolio Management. There are so many, and I list his full bio in the show notes at thelongterminvestor.com. Enough talk from me. Without further ado, here is my conversation with Mayer Statman. This is a lot comfier than my normal podcast setup. Well, I'm delighted to be with you one way or the other.

1:48Mayer, some of the books that you've written were extremely influential for me in the way that I work with clients, the way that I think about helping humans be humans. You can't take the human error out of humans. And so how do we address those issues? And so I thought we could just start at the highest level and let you define what is behavioral finance. So behavioral finance is the study of the behavior, the decisions of normal people, and how those decisions are reflected in financial markets. It is distinguished from standard finance in that standard finance is about rational people, how it is that rational people make decisions and how those decisions are reflected in financial markets.

2:37So people in academia, economists, financial economists, use the term rational more narrowly than it is used in daily life. In daily life, we might say it's not rational to buy a Lexus when a Toyota is essentially it other than the emblem. What Miller on Modigliani, Merton Miller and Franco Modigliani did in 1961 in a very famous paper that is a big part of their Nobel Prizes, they define rational people very well. They said that rational people, rational investors prefer more wealth to less, seems reasonable, and are indifferent to the form of the wealth. And the point of that second one is that dividends do not matter.

3:31Why? Because if you don't get a dividend from a company, then you can create homemade dividends by selling a few shares just to get whatever that$1 ,000 or whatever you wanted out of dividends. The problem with that is that that is not what people do. People care very deeply about dividends. And so my colleague, Hersh Sheffrin, and I wrote a paper in the early 80s where we elaborated on that. I'll tell you more about that. But essentially what we said is that people prefer dividends for two reasons. One is because they distinguish between capital and income. And second, because they hate to dip into capital.

4:22And so this rule may not be rational, but it is normal and pretty smart. Because what you're afraid of is that if you give yourself permission to spend 3%, you will say, you know, this time I need more. And you'll spend five or six or eight. And so, again, there's a difference between what is rational and what is normal. And normal can be pretty smart. I definitely want to get into some of these portfolio issues. but as you mentioned that you were publishing this work in the 1980s, I have to imagine that your work was initially met with some skepticism from other economists. What was it like publishing on these topics in the 80s?

5:06It was not a book. It was an article. It was an article published in the Journal of Financial Economics. At that time, sending a paper like that to the Journal of Financial Economics, which is a top finance journal, in fact, we didn't expect it to be accepted. We thought that we'll just get good referee reports that will help us later. And so people outside of academia will say things like, you published a paper. No, I don't publish a paper. It is the journal that published a paper. And God knows they make it so hard to get that because the typically it's kind of like getting admitted to Harvard.

5:49Five percent of the articles submitted eventually make it to publication. Now, we wrote an article. We called it Explaining Investor Preference for Cash Dividends. We were exceedingly luck, which tells you what you know, that luck matters greatly in life. The referee turned out to be Fisher Black, Fisher Black of Black Shoals. And the man is great in many ways, but he has really an open mind and an ability to really reach out and compare his personal experiences to what is in the literature. And he wrote such a brief, but such a positive report that the editor said, after some non-trivial soul-searching, I guess I agree.

6:47And so that article was published. But that was at a time when getting a paper published on something that we did not call at that time behavioral finance was extremely chancy. And so it's a combination of the innovation that Hirsch and I introduced and that luck of having Fisher Black as our referee. I absolutely love that story. And I think that a lot of people, it's so mainstream these days, behavioral finance, and they forget what it must have been like and how it wasn't purely accepted. And I graduated college in 2007 with an economics major, and there was not one mention of anything behavioral finance related.

7:31I took some psychology courses and there were some mentions there, but not in pertaining to finance. To me now, it's a little bit like when Moneyball came out and all of a sudden everybody started to talk about advanced statistics. The second generation of behavioral finance is a little bit different. I would love to hear your thoughts of what has evolved to in a second generation and even maybe perhaps touch a little bit on where you see it evolving today. In the early 80s, when I started in what became behavioral finance, there were really a very small group of people in addition to Hirsch and myself.

8:09Dick Thaler was there, Bob Schiller was there. There are, of course, giants who won Nobel Prizes and a handful of others. We built on the work of people like Kahneman and Tversky principally, but other psychologists, cognitive psychologists. And at that time, we had what I call now the first generation of behavioral finance. And the first generation of behavioral finance, in fact, called people irrational. So standard finance said people are rational. The first generation said irrational. And so we had things like overconfidence. So in fact, even today, The first thing that comes to mind of most people when they think behavioral finance is cognitive errors, emotional errors, excessive fear, representativeness, and so on.

9:04Well, that is all nice. But the thing is that people really distinguish or we should distinguish between what it is that is an error and what it is that people really want, what investors really want. And so not everything that we describe as an error is in fact an error. For example, we know from the literature that the more people trade, the more they lose. So you can describe it as an error. But then you think about video games. Why do people play video games? How much money do they make playing video games? Well, some people are professionals, but for most people, it is just a fun pastime.

9:52Can you imagine that for some people, trading is like video games? And so the point that I made is that when we think about any product, whether cars or watches or restaurants, we derive three kinds of benefits from them, utilitarian, expressive and emotional. And so the utilitarian benefits are how much money do you make of it? What does it do for your pocketbook? But the expressive is, what does it say about me to myself and to other people? I'm a religious person. I'm a fun person. I really enjoy the thrill of driving a fast car. And emotional, the pride. You make money and you support your family and you have money for retirement.

10:47But there is something about having more than that, such that you can create an endowment at your university that brings you this emotional benefit. And so you give up, in fact, utilitarian benefits because you give up money, but you gain more than that. And so in the second generation of behavioral finance, we looked at things, I looked at things like socially responsible investing. Why do people invest in it? Some will tell you that they make extra money out of it. That's not so. You lose money relative to what you would do if you did not, but you gain expressive and emotional benefits. And the usual answer of economists is separate the two.

11:33And some advisors will tell you the same thing. Separate the two. That is, I'm here to make you the most money, and then you can use it for whatever you like. And my standard response to that is to say this. Imagine that it's an Orthodox Jew facing you and you say, listen, pork costs less than kosher beef. It tastes pretty good. Why don't you eat pork and donate the savings to your synagogue? Everybody understands that that is absurd. For some people, having fossil fuel stocks in their portfolio feels like what it feels like an Orthodox Jew with pork in his mouth. If that is how you feel, don't have them in your portfolio.

12:18Don't have these stocks of whether it is fossil fuels or whether it is abortion drugs or whatever has to do with your values. And so this is kind of the distinction is that some things that we used to describe as errors are not really errors, but they are reflections of what people actually want. I love that distinction, errors versus wants. And I feel like it used to be, like you said, the first generation, it was a lot of, oh, look at you silly little humans. The second generation really delineates between it's OK to want these things, even if it is not optimal. One thing that I constantly encounter from portfolio construction is the type of investments people want.

13:04You'd mentioned ESG. Another thing that comes up quite frequently would be hedge funds and alternatives, which to be clear, I don't think are inherently bad, but sometimes the reason people want them can lead to errors. Sometimes they want them for the wrong reasons. Why is it that you find particularly wealthy people have such a high interest in hedge funds and alternative of private investments? So years ago, I was about to speak in Montreal to friends of the Hebrew University, the university I graduated from. And I was speaking to one of the people who was going to be in the audience. Of course, it had to do with investing.

13:43And so we were talking about investing. And I said something about mutual funds. And he said, I invest in hedge funds. So what did he tell me? He just told me that he is a wealthy man. Because we all know that the minimum for a hedge fund might be half a million dollars or perhaps a million dollars. Not everyone can afford that. Did he brag about his riches? If he said, hi, my name is Joe and I'm a rich man, that's gauche. But you let drop that you are into a hedge fund and you tell me the same thing, except that it is more than socially acceptable. And so my sense is that when somebody, say, sold a business, say, for$10 million, and he comes to a financial advisor, and a financial advisor says, here is a good portfolio for you that will preserve your wealth and increase it, composed of mutual funds and ETFs.

14:49And he says, you know, that's for the little people. I'm a big fish now. What you have that is special that I can speak about to my friends who also have that kind of wealth, hedge funds, private equity, give you that opportunity to really gain those expressive and emotional benefits. And if it loses you some money, who cares? In fact, one advisor who heads a family fund said, I have that owner has a wealth exceeding$100 million. He wants not 5%, not 5 million of play money. He wants 15%. And I was thinking for a moment and I said, you know what? if you have$100 million, you can lose$15 million and still be okay.

15:45If he finds that it enhances his well-being, let him do that. I don't know if it was the right answer, but I think that it is a reasonable answer. Well, I think that recognizing your desire for certain types of investments as a signaling device, much like you might buy a nice car, much like the shoes or clothes that you wear, all different forms of signaling status, which again, from an evolutionary perspective is very important and understandable. What I also think though, is so you're mentioning, I do encounter people where I sort of expand what I'll call behavioral tolerance bands. We have rebalancing, for example, where there are set tolerance bands, where when stocks become too big of the portfolio, you rebalance back.

16:27And when you do have a certain amount of wealth, we do give people a little bit more wiggle room with their portfolios. Now, I also know that if we had a properly functioning crystal ball, and it were to just put out right now in front of us, the assets we need to hold that will definitively be the best portfolio 20 years from now. I also know that there's a good chance I won't be able to coach a person through that portfolio. Just, I mean, people struggle holding international stocks, which is pretty basic right now. Who knows what the perfect portfolio would have. My question to you on that optimal portfolio perspective is how does the optimal portfolio from a behavioral perspective differ from the optimal portfolio from a mean variance or a CAPM basic modern financial theory portfolio?

17:11So let me tell you a story about mean variance portfolios and behavioral portfolios and Harry Markowitz. So Harry Markowitz passed away not long ago. He was a good friend of mine. He was a mentor, a very dear man, a very smart man, but he also understood investors. So he knew his mathematics, sure, but he understood human behavior. So I met Markowitz almost 30 years ago in 1995 at a conference, and I took the opportunity to sit with him at lunch. And I pointed to our plates and I used that to explain the difference between mean variance portfolio theory and behavioral portfolio theory. I said this, in behavioral portfolio theory, we like our plates to have the beef, the steak in the middle, the mashed potatoes at one side, the broccoli on the other.

18:21We like the steak to be hot. We would like our beer to be cold. In mean variance portfolio theory, you take all of those ingredients into a blender, mash them all together, and eat them with a spoon or suck them with a straw. That is, from the perspective of the stomach, it doesn't really matter if it's a steak or broccoli. It is all minerals, vitamins, calories, and so on. But of course, people care about those elements. People care about the special individual ingredients. People have goals. It might be education for the kids. It might be retirement for themselves. It might be a bequest, all kinds of goals.

19:10And Harry laughed as I was describing that. And that was the beginning of our friendship and his mentorship of me. And later on, we wrote a paper together with two other colleagues that combined the two that said, what do you do when you have those different goals? for example, education and retirement and bequest. You put each of them into a mental account as if it belongs to a different person. You optimize each of them by the rules of mean variance, and then you combine them. And what we found was that under some conditions that all of those three sub-portfolios lie on the efficient frontier, as well as the overall portfolio.

19:59So it is possible to do the normal thing to satisfy what people want and yet have it optimal in the standard finance way, because still we want it to be efficient. I'm never going to think of modern portfolio theory ever the same after that. That is a wonderful example. And I think of, again, if we're tolerating some behaviors in those that we're advising based on their wealth, based on how bad the worst outcome of making a deviation from the steak dinner milkshake that you just described. Obviously, neither you nor I are experts on fiduciary law. But I do know that we all try to do what is in our client's best interest.

20:43And so when you think about the difference between like the optimal behavioral portfolio versus the optimal mean variance portfolio. No one's really written on this topic about it being your fiduciary duty to do the right thing. How would you think about connecting those two ideas? Well, I think about it in the context of what is a want and what is an error. So think, for example, about dollar cost averaging. Dollar cost averaging is not rational. If you want to invest in stocks, If you just got, say,$100 ,000, you want eventually to invest it in stocks, invest it today, all of it, in a lump sum.

21:25There is both theory and empirical evidence suggested that is the way to do that. And if you received a bequest of$100 ,000 in cash, I'm sorry, in stocks, and you want it in cash, then sell the stocks today and you'll have cash. In fact, if you are very averse to risk, and this is why you want it all in cash, surely any day you hold stocks, you expose yourself to risk that you're going to lose some of that money. Suppose that you face a client who has this situation. He's just got$100 ,000 in stocks or in cash that he wants to put into the market eventually in stocks. And you say, look, both theory and evidence suggest that you should just do it today, just buy$100 ,000 worth today.

22:24And the fellow says, I don't know. I mean, you know, what is the fear? The fear is that the stock market is going to plunge tomorrow. And the God of the market will always do that to you. OK, as soon as you put in money, the market goes down just to tell you that you're stupid. So what is the real impediment? It is not attitudes towards risk. It is regret, which is an emotion that we all know. if the market goes down tomorrow after I invested today, I'm going to feel like an idiot. I'm going to have hindsight. Why did I do this stupid thing? I'm going to feel regret. Now, what you do when you do dollar cost averaging is you divide it, say, into 10 increments of$10 ,000 each, and you You invest each in the coming month.

23:19And this way, you minimize your regret potential, not risk is driving it. It is aversion to regret. Now, suppose that the client that you say, here's the rational thing to do. As a fiduciary, I'm trying to maximize your wealth. Here is what you should do. Invest it all today. Now, the client doesn't do that. The client is kind of like the fellow at the edge of the pool and you say, jump, jump head first. And he says, no, I cannot do that. Isn't it better to say, why don't you put in two toes first, then your feet, then your legs, then the rest of your body? This way, at least he gets into the water.

24:08And so I think, I don't know what the lawyers would say, but I think that if you explained to people what the literature, what the evidence is, here's the rational thing, and then they say, no, I'd rather do it by dollar cost averaging, this is the distinction between what is an error and what is a want. Then dollar cost averaging is not an error. It is a want to minimize regret. And while regret is not something that we accept in standard finance, you know, regret, whether you accept it in standard finance or not, regret is something we all have experienced and we all are deterred by decisions that might impose regret.

24:53I'm thrilled that you mentioned regret because the literature suggests that regret is strongest when you can clearly see the alternative path. And there is nothing more quantifiable than what just happened in the market. And I think it's why people put so much pressure on them. So I'm thrilled that you bring that up. But that is also what my role is and many of those in the audience role is, is to play a role in coaching and educating those who are helping. Can you speak to that a little bit? Yes. So regret is an emotion that we describe as a cognitive emotion. Unlike fear, when you are on the highway at highway speeds and the car in front of you slows down really fast, you don't say, what is the reason for that?

25:39Is there an accident? So on, you just slam on the brakes. That is what fear does instinctively. And that is a good thing. Regret is a cognitive emotion in that as you're going to make a decision, you think you can see what can come out. What if I chose this job rather than the other one and this did not work out right? What if I chose this fund, say a value fund over a growth fund and it turned out that in hindsight, I know that it was the growth fund that was better. And so you really have to kind of accept that and you have to know. And this really is where an advisor is an educator. You know, I tell advisors, you are like me, you are educators first and foremost.

26:36And say, here's what regret is. It is familiar to you. I know that we are making a decision now and the outcome will be only years from now. You might find yourself in a situation where you find in hindsight that you would have been better doing something else. In fact, diversification, one of the good things of diversification is that it can minimize regret because, yeah, I have some growth, I have some value, I have some domestic, I have some international. Unfortunately, clients people, we will come back and say, why did you invest in international funds? Wasn't it clear at the time that it is not going to do as well?

27:27In fact, one advisor told me of a trick she uses with her clients. At the beginning of the year, when they meet for the first time, she has a set of questions. You know, will Donald Trump be divorced? Will California have a seven magnitude earthquake and so on? And people say, here's what I predict. Then at the end of the year, of course, they remember only those predictions that came true. And so she can show them or at least can threaten to show them the list. And then they realize that their, as they say, their foresight is not as good as their hindsight. And perhaps they calm down. I'm not suggesting that it's easy to educate clients.

28:16You know, you have to do it again and again. You think that you explained it, but you don't. The usual thing that applies to professors applies here. There's no such thing as a stupid question. There is not a statement of, didn't we talk about it last time, just do it again, because people are people and you are trying to do the best for them. You're trying to improve their wealth and also their well-being. I love this idea of advisors as an educator. And my father, he is a pediatrician and it's obviously an evidence-based profession. And there's a lot of diagnostics involved, but then there's also points where the evidence isn't black and white, it's shades of gray.

29:00And a physician's job is to be an educator on those different options and help you make a decision that you will feel good about. Now, what I also learned from people calling my dad all throughout nights and weekends and asking for life advice is that the pediatrician was at a really unique intersect to sort of veer off of pure medicine and talk a little bit deeper into life. And I think that advisors have an equally good opportunity to expand beyond just the financial well-being and talk a little bit more about just well-being holistically. I know that you're doing some research on that topic now.

29:33What do you at a high level think about the difference between the financial well-being and the life well-being? I talked about the standard finance where people are rational. The first generation of behavioral finance where we describe them as irrational. And the second generation where we describe them as normal. What I describe today, and there's a book that is at the publisher now, is what I think of as the third generation of behavioral finance. And in the third generation of behavioral finance, people are still normal. But people want to enhance their well-being, their life well-being, beyond financial well-being.

30:16For example, what are the domains of well-being? Finances, and I'll come back to that, but also family and health. and work and education and religion and society. There are many dimensions to it. And so what we do is eventually, or what you do as an advisor, and you don't need to hear it from me to know, because this I'm sure is your practice. You are trying to enhance their well-being without without detracting too much from their wealth. And so you might say to a client, why don't you share your wealth now? An old person saying his 80s, why don't you share your wealth now with your children, family, charities, rather than wait for you to be dead?

31:11And so I say, it is better to give with a warm hand than a cold one. The time to give is earlier, not when you die at 95 and your kid is 65. The time that kids need that money is when they are in their 20s. Yeah, you paid for the college maybe and they have loans. This is the time for you to do that. Some years ago, I was speaking to financial advisors about those issues of saving and spending and so on. After my talk, as I stepped down, people approached me talking about the need to save more and spend less and so on. There was one advisor who stood aside and she said when those others have left, she said, I started crying when you said it is better to give with a warm hand than a cold one.

32:11She, in fact, had tears in her eyes when she spoke to me. And she described how she lent her son some$27 ,000 for his education, for his college education. And now she insisted on him paying back by the agreed upon schedule. Her reasoning was that this will teach her son financial responsibility. You sign the contract, you have to fulfill that. But that kid was now at the beginning of his career, and he did not even have money to buy his girlfriend an engagement ring. And of course, it soured their relationship. And so I hope that she got that message that by forgiving that loan, which she could do, I asked her, she could do that without harming herself financially.