Episode 258: Prof. Meir Statman: Financial Decisions for Normal People

32:17Because if it is called, then let's say the exercise price is 55 and the stock is at 50, you'll still get that$5 between 50 and 55 dollars. And then he says, you know, what you're going to lose are those uncertain things that happen if the price goes beyond 55. Of course, if you find that the stock price has gone not to 55, but to 75, you're going to again feel like an idiot with regret. And so what people do, people are kind of fooled by this framing of three sources of losses, and they don't realize that when they buy a call, somebody is selling that call, and that somebody might not be stupid, that somebody might know something that you don't.

33:09And so it is really, again, rationally speaking, it makes little sense. But behaviorally, normally, it does make sense. And so this is covered calls. And, you know, structured products, again, structured products are arranged such that they have a floor. You cannot lose. You're sure to get your money back. So it goes like if you put in$1 ,000, you're sure to get back at least$1 ,000. And on top of that, say half the increase of the S &P 500. Well, what happens is, of course, whoever creates that structured product is doing it by buying a zero coupon bond and a call option. And they, of course, make money off that.

34:01And then there are some other things that go. One, it is expensive because of the money that the bank or whoever has created it. And also using, again, the issue of mental account. First, they don't count the dividends. And so if you were to actually hold the stock, you would get the dividend. And second, if they give you back$1 ,000 after 10 years, well, the real money that you get is less than$1 ,000 because inflation, even at 2%, it takes a chunk. And so it is really designed to appeal to people, kind of like tasty ice cream, that is going to settle in your waistline. so we've seen research showing that these things are overpriced by like five to eight percent i look at that and it's like that's objectively a bad thing to buy could it actually be justified by their behavioral benefits well the difference between what is an error and what is a one so let's say that i am a trusted teacher and i tell a student listen you will pay eight percent on top of that, on top of what it really is worth.

35:18Is it worth it to you? Now, if they say, whoa, now I understand that I will never touch them again, then I know that it was an error or ignorance that caused that person to buy them. But if they say, well, I'll still do that, just as the person who says I'll still buy lottery tickets, then I understand that that is what they want. The pain for them of losing money may be so great that they're willing to pay an extra 8 % to avoid that pain. It might not make sense to me, but it makes sense to them. To me, it makes no sense to buy a Lexus when I can buy an equivalent Toyota. But I don't think that people who buy Lexus are stupid.

36:05They just are status-seeking in ways that I am not. You know, I'm starting to seeking in other ways, but not in automobiles. My main car, well, my wife just insisted to get a Subaru Outback for me, but my real car is a 1994 Toyota Camry station wagon. That's awesome. But that definition of the difference between errors and wants, that was incredible. Very, very cool. Why do normal wealthy people want to invest in hedge funds and private equity despite their questionable benefits to a rational investor? Well, that comes back to the issue of status seeking that I described. In fact, one person, an advisor who sort of sells or recommends hedge funds and the like, told me that when an investor comes to him with, say,$10 million after he sold his business, if he says, well, you can invest it in index funds, well, the minimum to invest in an index fund might be$3 ,000.

37:12You know, he says, I don't want to be with those little people. You know, I am now a big shot. I have$10 million. Let me have something that is unique to those high ones. And so when you buy a hedge fund and when you tell people, you know, if we have a conversation about investments, so you're not really bragging, you're just telling me that you invest in hedge funds. Well, I immediately know that you are at least moderately rich without you being so crass as to say, hi, I'm mayor and I'm a rich man. And so people buy hedge funds for the same reason that people buy Lexus and Mercedes-Benz and another luxury cars.

37:58Yes, they take you from A to B, but they also tell other people and tell yourself that you are a big shot. Okay, I want to ask your opinion on a very practical question for us, because we believe in index funds being the most sensible investment for most people, but we also have seen the exact scenario that you just described. Should people in our position be catering to that, to that want for more exotic investments? Well, my sense of financial advice is that you, like me, are teachers first and foremost. And so it comes back to the difference between error and want. If your client thinks that, in fact, hedge funds are riskless assets with returns that are fabulous, then you can disabuse them of that notion that you can teach them.

38:49But if they say in one way or another that they want to feel special, then what can you do? You do that, you try to minimize the damage in the same way that if you have a client or a prospect who wants to avoid, say, oil companies in his or her portfolio, you don't really say, look, I'm here to just make you money and then you can do with it whatever you want. You kind of listen to them and you try to find the solution that is consistent with their values, but it is not too expensive, does not damage their wealth more than can be done. Really interesting. So it's kind of like making sure that they understand the tradeoffs and then you can kind of gauge whether it's an error or a want.

39:39Yeah. And again, remember, the issue is well-being. What you're trying to do is maximize the well-being of your clients. And you do that in a gentle way. And you realize that well-being is different for different people. That is, if a friend told you that he has two offers, you know, one that is a job that he's going to hate, but makes a lot of money and one that makes enough and more than enough, but he's going to be happy to get up in the morning and do that work. You're going to say, what are you trying to do with your life? Do you really want a job where you're going to hate it every day just because it pays you more?

40:22And so you see that people come to different conclusions. Some people go to investment companies where they work like dogs and make a ton of money and then, say, retire and live off that. and other people choose to be, say, professors or financial advisors, making more than enough money to live on, but not fabulously wealthy and maximize their well-being this way. We talked about regret earlier. How do you think normal households should deal with currency hedging in their portfolios from the perspective of regret? Yeah, well, you know, that is always the case. So let's say that you invest in foreign markets, foreign stocks.

41:07So the value, your returns in dollars are a function of how much those, say, Japanese stocks have gone up in yen and what happened to the value of the yen relative to the American dollar. Now, generally, those funds do not hedge against currency fluctuations. And that is a good thing. But if you have a situation where the currency fluctuations kind of hurt your returns in dollars, people become sensitive to it. And so it really is an issue less for individual investors and more for institutional investors and lots of institutional investors have gotten into the habit of hedging half of it. So they kind of minimize their regret by having, well, you know, I have a bit of this and a bit of that, and I'm happy about that and sad about that, but it kind of cancels out that kind of psychological mind game that we are all subject to.

42:14So I say forget it, you know, just do it in a cheap way, because if you buy Japanese stocks and then hedge the yen, you'll pay extra for the hedging part. It's not worth doing. Since we know about all these normal but potentially suboptimal behaviors, what should normal investors do with this found knowledge? I think that if investors are educated, and by educated, I don't mean financial literacy in the sense that it is usually measured. That is, do you know about compounding? Do you know that when interest rates go up, the value of bonds goes down? But rather, if you know the science of finance, that is, if you know the facts, if you know, for example, that more often than not, active mutual funds trail index funds, and therefore it is wiser to buy index funds.

43:12And by the way, even if on average, active funds do better than index funds, there's going to be a range. You know, some of them are going to trail the index by a lot and some of them are going to beat it by a lot. But you don't know ahead of time which is going to be. The nice thing about index funds is that you're going to be always in the middle, always mediocre. But I say it's better to be mediocre than to be the GOAT. And so that is what I do. And so if people have true financial literacy, such as I described why index funds are superior, then they're going to make wiser decisions. then they're going to, for example, do dollar cost averaging.

44:02Fine. It's no big deal. Fine. Just divide it into 10 chunks. That's not really a big deal. But if you chase the recent trend and concentrate your portfolio in whatever technology or health or whatever, that I think is less than wise. It sounds like it's another case of the understanding the difference between errors and wants. Yeah, that is right. Yeah. I think there was a clothing store that said, an educated customer is our best customer. Yeah, I like that a lot. Okay. So we've been talking about the behavior of normal investors as opposed to rational ones. I want to move on to portfolio theory.

44:47How is behavioral portfolio theory different from traditional mean variance portfolio theory? Here's a story. I met Harry Markowitz in person almost 30 years ago at the conference. In fact, I told that story because I spoke at the same conference just a month ago. And so when we sat down to lunch, I took the opportunity to sit with Harry Markowitz. And of course, we engaged in a conversation. And I explained to him what behavioral portfolio theory is all about by pointing to the food plate that was in front of him and in front of me. And I said this, mean variance portfolios look at the world from the perspective of the stomach.

45:36That is, they know that the steak and the mashed potatoes and the broccoli, you know, they're just there because they are carrying nutrients and vitamins and so on. So why don't we just put them all in a blender and then suck it in with a straw? You get the same vitamins and nutrients and so on. Now, what I say is that behavioral portfolios are one where you want your steak hot, you want your mashed potatoes hot, you want your beer cold, and so on. And Harry Markowitz understood it immediately. He is a wonderful man. I'm really a very fortunate man to know him. And he understood it perfectly. He understands investors.

46:28And in fact, years later, the two of us, Markowitz and I, and two of our colleagues, wrote a paper that kind of combines mean variance portfolio with behavioral portfolio theory, such that people keep their money in different mental accounts. There's money for retirement. There's money for education. There's money to leave for the kids. And yet you can do that in a way that is efficient, in a way that lies on the efficient frontier. And so this really, again, it all kind of comes back to the issue of well-being that underlies it. That is, how is it that you can help people maximize their well-being?

47:12In fact, I tell a story, kind of apocryphal story, about going to an advisor and he does a Monte Carlo simulation on all my assets and goals. And he says, Mayor, I have a wonderful news for you. You have a 90 percent chance of achieving all your financial goals. And I go home to my wife and I said, I just found that there's a 10 percent chance we're going to live in the street. compare that to if the advisor puts my money in those two buckets one for not being poor one for being rich and now i say to my wife i learned that our retirement is going to be secure we'll have money for car for fixing the roof and all of that and on top of that we have a 20 chance to leave a good chunk of money to the kids it is the same money but it feels differently because it is framed in those mental accounts that correspond to the particular goals I have.

48:14So goal-based investing is really built on behavioral portfolio theory. I've got to say that food analogy was incredible on many levels because I think you can even take it a step further and say that the food in the blender is even a little bit more efficient and maybe the mean-gurrence program. Exactly. Yeah, you can dump it up faster. Yeah, yeah. Those bits of knowledge that you get along the way kind of come back really in an insightful way. When I was a student at the Hebrew University many, many years ago, there was really a footnote in a book by Samuelson, but something that George Stigler, also a Nobel Prize winner, did early on.

48:55And he calculated what is the best diet if you want it to be the least expensive one that satisfies all your nutrition needs. And all you need is kind of five or six evaporated milk and beans. And, of course, you kind of look at it and say, well, it may work for pigs. I would like to have some chocolate from time to time. And so that is, again, you really have to understand people, people like me, people like you. We like to have more than the minimum cost diet. I must say, Mayor, I love your stories. So how does the marketplace portfolio theory get applied to behavioral portfolios? So, you know, kind of coming back to what I just said, that is, if a client comes to you as an advisor, just saying that your overall portfolio, a return of whatever, of 10 % or minus 20%.

49:58In fact, clients, as you know, hate the idea of putting all their money into, say, a global mutual fund. They want to have the equivalent of the steak and the beer and so on, so that you as an advisor can say, well, yes, I know we have lost money on these stocks, but we made money on the international stocks or the large stocks or the value stocks and so on. By having those separate entities, you can kind of in some way comfort investors. Of course, many investors will really zero in on the one that did the worst. And they're going to say, They say you chose for me that stupid investment that went down and you're an advisor, so you should have known that ahead of time and so on.

50:47I know that life of advisors is not perfect either. How would a portfolio optimized for behavioral portfolio theory look through something like the CAPM lens? I don't really know that CAPM enters into it. CAPM is kind of built on mean variance portfolio theory, and it is a very nice and neat model. This is why we kind of, we professors like to present it to our students. But, you know, we've moved away from it. Now we are talking about a three-factor, four-factor, five-factors, God knows what it is. It is really when people say, well, you know, behavioral finance is really nice and I understand the stories and so on, and my husband or wife behaves this way, blah, blah, but it does not have the rigor or the heft of sudden finesse, I say, what are you talking about?

51:46Think about mean variance. Who is actually applying mean variance as mean variance? That is, you put reasonable parameters into an optimizer and it comes back and it says, put 70 % in Russian stocks and the rest in Bitcoin. Whoa, you say, okay, no Russian stocks, so you have a constraint, no Russian stocks, and no more than 3 % in Bitcoin. And then you eventually, with those iterations, you get what you wanted in the first place, but now you can say Nobel Prize winning strategy, blah, blah, blah. What is the asset pricing model of standard finesse? It is no longer the CAPM. It is a mess. It is really, they talk about the factor zoo.

52:33So what I think of as behavioral finesse is that it provides a realistic picture of the world of finance. And then it also provides with it kind of guidance as to how you can increase your well-being the most by knowledge and by guidance of advisors and by the kind of hand-holding. So this is why I describe financial advisors as financial physician. It is not enough that you know the intricacies of covered calls and the stocks, bonds and the rest of it. You really also have to have the kind of bedside manner that physicians have to really increase people's well-being beyond just increasing their wealth.

53:29That was awesome. I want to repeat part of it back and make sure that I interpret it right. The models of standard finance are messy enough that to evaluate a behavioral portfolio and call it suboptimal would almost be irrelevant because the models are so messy anyway. Does that make sense? Yeah, that generally makes sense. Now, there are some things, you know, that is diversification. That is really part of mean variance. But actually, diversification and the benefits of diversification were known before. mean variance and so on that has been with us forever. And so the issue, again, is how to use knowledge for the benefit of investors, clients, students.

54:12And this means knowing not just the facts of finance, you know, that when interest rates go up, the value of bonds go down, but also knowing people. I always tell the story that I heard years ago from one advisor about a couple that came to him and they said, before you start planning for us, you should know that we have a disabled son and we have to arrange for resources for him when we are gone. So every family has its points of pain and a good advisor, like a good physician, finds those points of pain And sometimes people are not saying that, you know, so you really have to be kind of like a physician.

55:04There are some things that are embarrassing that you are embarrassed to disclose even to your physician. But when you have a physician that you trust, you do that and then you create a connection that is more than maximize my return. And the same applies here. So when clients kind of disclose their points of pain, and I say, you know, if it is comfortable for you as an advisor, disclose your own, because then people are going to be open with you. Because if they think that you're perfect and they have this problem, they may not share it. But if you tell them that you are imperfect either, then they will do that.

55:51And also tell them, you know, that is when they come and they say, I'm afraid of the market and all of that. You can begin by saying, I understand that because I too am afraid. Here is what I do. That is the knowledge I have is what I have that you don't have. And my service to you is imparting that knowledge. Interesting. You mentioned factors. How does behavioral theory interpret the return premiums that come from these factors like size and value? Initially, when Fama and French introduced their three-factor model, they said that size and book-to-market are, in fact, proxies for risk. Well, there have been many papers that looked at it and they said, no, it cannot really be proxies for risk.

56:38Kershefren and I wrote a paper where we made the point, argued that they are really proxies for people's want. And so growth stocks are more prestigious. You know, they're likely to have a Tesla and they're likely to have Facebook and they're likely to have all of that rather than General Motors and Ford and so on that are in the value category. And so people prefer, say, large stocks, gross stocks, because of the same reason that some people prefer a Lexus to a Toyota. That is still likely the case. But you also see that value and size have been dogs for two decades now. And so I wouldn't put a lot of stock in that either.

57:33and I'm kind of more inclined to think that there's just too much randomness in it. And by the time you find that there's a particular factor that works, distinguishes high returns from low returns, this is just the time when it stops working. And this is why I really don't have much of a tilt in any direction. Now, I do have a growth fund and a value fund, you know, index funds, But now it is kind of for historical reasons because the growth fund has a lot of capital gains that I don't want to realize. And by having roughly the same amount of growth and value, I have in fact the equivalent of a total market portfolio.

58:18Very interesting to hear about your portfolio. How do you think that the typical risk profile questionnaires that financial advisors use can be adapted to improve the behavioral dimension of decisions that we've been talking about? Well, there are many questionnaires, as you surely know, and some of them kind of claim that they are built on whatever scientific principles. Some of them actually have questions that are not about risk, but they are relevant. For example, they will ask you about, say, they'll tell you a story. Here's a company where you've lost a good chunk of money on their stock, but now they've been reorganized and they have new management and so on, would you invest in it?

59:02Well, this really is a question not about risk, but rather of regret. That is, this is a case where that dog bit you, and now they're telling you that it is a well-behaved dog. Are you going to trust it or not? You remember the pain of that bite is still with you and all of that. Then there are questions like you feel confident in your ability to choose stocks. Well, this is about overconfidence and people who are overconfident are willing to choose risky stuff. Of course, they're going to scream when it goes down, but that is what they do now when they answer the questionnaire. So I don't really put much trust in these.

59:42I think that advisors use them mostly to cover the rear end if the client sued. But having a conversation with a client that highlights those issues of hindsight and framing and regret and risk, that is valuable. And you can do that with a questionnaire or I think better yet, do it as a conversation with clients to really fit their portfolio to who they are and what they want to do. You've mentioned the role of financial advisors quite a few times. what role do you think they should play in correcting behavioral errors of clients? Well, as I said, advisors are like me. You know, they are educators first and foremost.

1:00:30And so it is really important for them. I was asked, should they explain those cognitive shortcuts and errors? I say, of course they should. It's not like a physician who knows that a patient has cancer and he says, no, no, no, this is just a slight pain in your stomach. You really have to be mindful, of course, do it gently. So for example, hindsight, you know, I always say, always begin by admitting that that is an error that is known to you as well. You're not smarter than your client. You just know more. And so let me explain to you how hindsight is working, how framing is working, how overconfidence is working, and so on.

1:01:14That really is a big part of what advisors do. Now, how much do you bend to your clients? Well, as I said, you know, if somebody comes and says, I want to be socially responsible, and this is what it means to me, an answer that, you know, I'm here to make you money, and then you can do what you want, tells that prospect, this fellow does not really listen to me. He doesn't care about me. He has one solution that he's going to shove down my throat. I actually use this analogy a lot. And I say, imagine that it's an Orthodox Jew who is facing you. And you say, listen, pork tastes pretty good, costs less than kosher beef.

1:01:57Why don't you buy and eat pork and donate the savings to your synagogue? Everybody understand that that is ridiculous. And to somebody who feels that having oil stocks in his portfolio feels like pork in the mouth of an orthodox man, then avoid these. But if you think that you are doing good to the world by avoiding oil stocks, then an advisor should explain that that is simply not true. And that may take more than a few minutes to explain how markets work and why you do no good by excluding oil from your particular portfolio. I have great admiration for conscientious advisors. They really have a hard job.

1:02:45I, as a teacher, I really try to educate all my students, every one of them. But sometimes there is somebody who says, you know, I didn't really learn anything or something like that. It really is very painful. But I still get paid by the university, not by that student. And of course, advisors, you know, if they don't satisfy a client, the client leaves and there's no more revenue from that client. And so you are in a more difficult situation than I am. And so I describe your work as being sacred work, kind of like a priest or minister or rabbi, because you are responsible for their financial well-being and ultimately life well-being.

1:03:37Are there other ways that financial advisors like us can use behavioral finance principles to improve our client outcomes? Well, I don't know that I have much to add beyond that. I think that, again, if advisors know that what they are trying to do for the client is enhance their well-being, then they're going to educate them on financial instruments, financial markets, the kinds of wants and cognitive errors and emotional errors and so on, then be patient. If I explain something and I see in the eyes of my students that they didn't get it, I don't say my students are stupid. I say I didn't explain it well.

1:04:22So let me see if I can explain it better. And if you explain to a client that it's not a good idea to let fear cause you to get rid of all the stocks in your portfolio, and you think that you just did it, and then comes another dip in the market, then the client is calling you again with the same story, just be patient. Explain it again. Don't say, didn't we just talk about it? Why do you bother me with a question that I already answered? Just be gentle, because people are vulnerable. And because, again, good advisors, good financial advisors are good financial physicians, good at both knowledge of the facts of finance and how to convey them to their clients.

1:05:10What do you think puts financial advisors in a position to give well-being advice? Because, like, they're not a therapist, they're financial advisors. Yeah, well, I think that there's just a need for advisors to change their view of who they are. I spoke at a CFA, it might have been the one that you attended, a CFA Institute on Wealth Management. I remember that Charlie Henneman, who used to organize those conferences, we talked about it because CFAs are resentful of CFPs because they say, we, with our education, we know a whole lot more about hedge funds and about strategies and so on. Why is it that people actually prefer CFPs to us?

1:06:02And the answer is that CFPs at least learn something about behavioral finance and they learn something about how it is that you can help people knowing people's proclivities and so on, how you can use behavioral finance, in fact, to help them. Now, the CFA degree, of course, includes behavioral finance as a component, but still, some financial advisors behave as if what they really would like to do is to manage a hedge fund. And now they have to deal with those stupid individual investors. And that, of course, rubs on clients, you know, and they don't like it. So what you need really is less of those geniuses at investments and more at good people who can manage investors.

1:06:54know enough about investments, but then know how to help investors. And so I say, I mean, I know generally about hedge funds, but I don't know the intricacies of hedge funds. Do I need to know that? No, I don't, you know, any more than I need to know exactly how my car goes from engine to transmission and to the wheels. I just know that somehow I turn on the engine and I go. And the same applies to advisors. So advisors need a different kinds, different set of skills. And by the way, those technical skills, robo-advisors do them at much, much lower costs. You know, realizing losses, they do that, harvesting losses, they construct portfolios, they do those questionnaires, and so on.

1:07:46So if you think that you're competing pie chart against pie chart, you're going to lose. The thing that binds clients to you is the thing that binds patients to physicians. Yeah, I totally agree with you. I asked the question because I could imagine listeners wondering the same thing, but you absolutely delivered an excellent answer. We've got two more questions for you, Mare. On the topic that we were just talking about, do you think that financial advisors should be pursuing education beyond reading your papers that aligns with becoming well-being advisors? Well, education is a wonderful thing.

1:08:24I, for example, subscribe to SSRN.com, and I think that it is reasonably free. And I just delight in reading abstracts of new papers as they come. and they kind of say, wow, this really is fascinating and this really expands my knowledge and this relates to something that I already know. And I think that advisors can do that. Now, most of the papers are of no interest. You know, I just scan them and I shove them aside. But there's more than one gem per day that I find and I keep a list of those abstracts and so on. I think that advisors would do well to subscribe to this and read it. And so there's a need to kind of learn in an efficient way.

1:09:15You know, you don't have to read the entire paper. Most of the times an abstract gives you all you need and it is much faster. Final question, Mayor. How do you define success in your life? Well, I think that success is well-being. I know that I am a successful man now because my well-being is much higher than it used to be. I know that I have enough money such that I can spend comfortably. I can treat others to dinner and so on. And either because I've reached my aspirations or because I've tempted down my aspirations sufficiently, that I just let things slide. You know, sure, lots of people have more money than me.

1:10:07And lots of people publish more papers than I did and wrote more books and so on. But I'm really happy with what I have. And more than that, I am happy in my ability to help other people, of course, students in the classroom and readers of my books and articles, but also people who simply have less and have lower well-being. And so we contribute. My wife and I contribute a good deal of money to charity, to people who need help. We established an endowment at Santa Clara University to help members of the faculty do their research and teaching and not worry about whether they're going to have enough funds for it.

1:10:57I just let things slide. There is this joke about the tombstone that says, published but perished anyway. And I say, you know, like all good jokes, it is funny because there is a grain of truth in it. I say, really quoting a friend of mine, 10 years after I'm gone, only my children will remember me. Well, maybe a student or two, I hope more. But I kind of know the difference between what really matters and what does not. And I focus on those things that enhance my well-being. What a beautiful cap to an incredible conversation. Mayor, we're so appreciative of you joining us. Thank you so much. Thank you.

1:11:42I'm delighted to speak with the two of you, and I look forward to being in touch again. Thanks, Mayor.

1:11:55Thank you.