Building blocks of Behavioral Finance
Meir Statman
Some years ago I was on a bus with fellow academics on our way to a conference dinner. I tried to persuade a seatmate I had just met that we want more than utilitarian benefits when we choose a car. We also want expressive and emotional benefits. My seatmate disagreed, insisting that he chooses cars by utilitarian benefits alone. His colleague, sitting behind us, chuckled. It turned out that my seatmate was a fan of expensive sports cars, quite willing to trade utilitarian low price for expressive prestige and emotional thrills.
My seatmate is not alone in blindness to his wants. We all need mirrors to see ourselves as we truly are. I hope you see yourself in this book and learn to identify your wants, correct your errors, and improve your financial behavior.
Behavioral finance teaches financial lessons to all— financial amateurs and professionals alike. Indeed, financial professionals distinguish themselves from financial amateurs by knowledge of the lessons of finance. Amateurs encounter financial questions in their roles as savers, consumers, and investors. Financial professionals encounter them in roles such as investment managers, corporate managers, and financial advisers.
The lessons of behavioral finance guide us to know our wants. They teach us about financial facts and human behavior, including making cognitive and emotional shortcuts and errors. And they guide us to balance our wants and correct cognitive and emotional errors on the way to satisfying
our wants.
These lessons draw on what we know about us— normal people—including our wants, cognition, and emotions. And they draw on the roles of these factors in behavioral portfolio theory, behavioral life- cycle theory, behavioral asset pricing theory, and behavioral market efficiency.
LESSON 1: KNOW YOUR WANTS
We want three kinds of benefits— utilitarian, expressive, and emotional—from all products and services, including financial products and services.
Utilitarian benefits answer this question: What does something do for me and my pocketbook? Expressive benefits answer this question: What does something say about me to others and to me? Emotional benefits answer this question: How does something make me feel?
Our wants regarding automobiles include the utilitarian benefits of safety, as by a Volvo; the expressive benefits of high social status, as by a Rolls Royce; and the emotional benefits of exhilaration, as by a Ferrari. Our investment wants include the utilitarian benefits of safety, as by an insured bank deposit; the expressive benefits of high social status, as by a hedge fund; and the emotional benefits of exhilaration, as by a successful initial public offering.
Ferrari, the auto maker, conducted the initial public offering of its shares in late 2015. The offering price was set high and shot up higher on the offering day. Sergio Marchionne, the CEO of Fiat Chrysler Automobiles, which owns Ferrari, did not pitch Ferrari’s shares as those of an auto maker.
Instead, he pitched them as emblems of high social status, like Birkin hand-bags made by Hermès or cashmere sweaters made by Brunello Cucinelli, the Italian luxury apparel company.
The utilitarian benefits of Birkin handbags that cost many thousands of dollars and Cucinelli cashmere sweaters that cost a few thousand are no greater than the utilitarian benefits of no- name handbags that cost $200 and no- name sweaters that cost $100. All handbags carry our stuff, and all sweaters keep us warm. But Birkin handbags and Cucinelli sweaters satisfy certain expressive and emotional wants that no- name handbags and sweaters cannot satisfy.
The utilitarian benefits of a Ferrari automobile in the six- figure range are no greater than those of a Toyota automobile costing five figures. Both take you from home to work and back. Indeed, the utilitarian benefits of Ferraris are lower than those of Toyotas and their utilitarian costs are higher because Ferraris consume more gasoline, cost more to insure, and are more likely to catch the eyes of highway patrolmen dispensing speeding tickets. But Ferraris satisfy expressive and emotional wants that Toyotas cannot satisfy. An eighty year old in a Toyota is old, but an eighty year old in a Ferrari feels young.
The utilitarian benefits of hedge funds are no higher than those of index funds. Indeed, the utilitarian benefits of hedge funds are likely lower because their returns to investors are lower and their fees higher. But hedge funds offer investors the expressive and emotional benefits of high social status because they are available only to the wealthy, whereas index funds are available to almost all. Similarly, the utilitarian benefits of shares sold at initial public offerings are no greater than those of shares of established companies. Indeed, the utilitarian benefits of IPO shares are likely lower because their returns are likely lower. But shares sold at initial public offerings offer emotional benefits of hope and exhilaration that established companies’ shares cannot match.
LESSON 2: KNOW FINANCIAL FACTS
Knowledge of behavioral asset pricing models is one example of financial-facts knowledge. A behavioral pricing model of automobiles decomposes their prices by features, costs, and benefits, whether utilitarian, expressive, or emotional. A basic Toyota Camry LE costs $22,970. An auto- dimming rearview mirror adds $329 to that price, a garage door transmitter adds $329, and a power moon roof adds a further $915.
A behavioral asset pricing model of investments similarly decomposes their expected returns into their features, costs, and benefits, whether utilitarian, expressive, or emotional. A typical low- risk stock might have a 6 percent expected return. The feature of higher risk adds utilitarian costs, compensated by an added 2 percentage points to the expected return. The feature of admiration, as toward Apple, Alphabet (Google), or Facebook, adds expressive and emotional benefits to their stocks, penalized by a subtracted 1 percentage point. The feature of “sin,” as in tobacco, adds expressive and emotional costs to tobacco company stocks, compensated by an added 1.5 percentage points.
Knowledge of the two versions of efficient markets, those of price-equals- value efficient markets and hard to- beat ones, is another part of financial- facts knowledge. Price- equals- value market efficiency in automobile markets implies that the value of a power moon roof equals its $915 price. Hard- to- beat market efficiency implies that while it is possible to find and buy a power moon roof for less than $915, doing so is hard, requiring effort such as Internet searches and negotiations with dealers.
Price-equals-value in investment markets implies that the value of the expressive and emotional benefits of avoiding stocks of sin companies equals its 1.5-percentage-point subtraction from expected returns. Hard-to- beat market efficiency implies that it is possible to construct a portfolio that excludes stocks of sin companies without subtracting 1.5 percentage points of expected returns, but doing so again is hard, requiring effort such as digging out exclusively or narrowly available information.
Financial amateurs and professionals often speak as if the mere observation of markets that are not price- equals- value efficient implies that they are also not hard to beat. Many fail, however, to distinguish between those two versions of efficient markets, and many fail to know the market- sum nature of investment markets.
Think of stocks as ingredients of a stew, some with fat returns and some with lean. Now think of a stock market as a giant well- mixed pot of stew that contains all stocks. Index investors dip their ladles into the stew and fill them with fat and lean elements in proportions equal to those in the pot. Beat-the-market investors strive to fill their ladles with higher proportions of fat than those in the pot. But it is impossible for all beat- the- market investors to succeed because the pot game is a pot- sum game and the market game is a market- sum game. If the ladles of some beat- the- market investors contain higher proportions of fat returns than the proportion in the market pot, the ladles of other beat- the- market investors must contain lower proportions of fat returns than the proportions overall.
Evidence indicates that investment markets are not price- equals- value efficient but are hard- to- beat efficient. The lesson for professionals is to attempt to beat the market by digging out exclusively or narrowly available information. They should know, however, that their attempts at beating the market are costly and often fail. The lesson to amateurs is to refrain from attempts at beating the market, choosing low- cost index funds instead. They too should know that attempts at beating the market on their own are costly and most often fail, and their attempts at beating the market by hiring beat-the- market professionals are also likely to fail because fees charged by beat-the- market professionals are higher than fees of low- cost index funds.
Knowledge of the benefits and costs of diversification is another example of financial- facts knowledge. An undiversified portfolio consisting of a few stocks can deliver the utilitarian, expressive, and emotional benefits of great riches, but it can also impose the costs of deep poverty. A diversified portfolio, in contrast, is likely to deliver the benefits of modest riches or impose the costs of mild poverty.
The benefits and costs of diversification are evident in a November 18, 2015, email from Motif, an online brokerage that offers undiversified thematic portfolios consisting of no more than 30 stocks. The gain of the Buy-the- Dip theme during the month ending that day was 10.7 percent, the gain of the Onward- Online- Ads theme was 9.5 percent, and the gain of China- Internet was 8.6 percent.
But not all themes delivered gains. The loss of the Precious- Metals theme during the month was – 18.7 percent, the loss of the Dr. Copper theme was –16.3 percent, and the loss of the For- Profit- Colleges theme was – 12.1 percent.
VTI, an exchange traded fund diversified among thousands of stocks, gained 2.2 percent during the month, much less than the 10.7 percent gain of the Buy- the- Dip, but much better than the – 18.7 percent loss of the Precious-Metals theme. We should consider balancing potential gains and losses through diversification.
LESSON 3: KNOW HUMAN BEHAVIOR
Cognitive and emotional shortcuts lead us on the right path most of the times but can also mislead us into errors. Human- behavior knowledge helps us distinguish shortcuts from errors. The cognitive shortcuts and errors of representativeness are one example. We use representativeness shortcuts correctly when we assess an email offer by Ms. Neomi Surugaba to share $20 million. Representative information indicates that it is a good deal. We would receive $4 million from an account left in an African country by this relative of a corrupt official for nothing more than our bank information. We reject Ms. Surugaba’s offer because we properly consider not only representativeness information but also base- rate information.
That information tells us that, on average, deals such as those offered by Ms. Surugaba are scams yielding losses rather than gains. Representativeness shortcuts turn into representativeness errors when we consider representativeness information but fail to consider base- rate information. Listen to a commercial by a commodities broker.
Man: I really need to diversify.
Woman: Stocks aren’t the only game in town. I tried commodities.
Man: What do I know about pork bellies?
Woman: Well, trade what you know. You know about gold, right?
Crude oil? … With commodities you don’t have to worry about stuff like PE ratios or CEO scandals. … It’s a pure price play.
Man: Interesting …
Announcer: Commodities are everywhere; what are you trading?
Representativeness information about gold and crude oil indicates that they are easy to analyze and offer good opportunities to beat the market, unlike stocks, which are difficult to analyze. But base- rate information indicates that gold and crude oil markets are no easier to beat than stock markets, because all investment markets are market- sum markets.
Some investors are bound to lose in the gold and oil games, earning below-market returns. Losers are likely amateur investors like the people in the commercial whose information about gold and crude oil is widely available, extending little beyond what is printed in newspapers and seen on television. Winners are likely professional investors employing exclusively and narrowly available information. And the commodities broker is a sure winner, collecting commissions from both losers and winners.
The emotional shortcuts and errors of affect are another example. Affect is the faint whisper of emotion or mood. We use affect shortcuts correctly when we continue to watch a movie if we find its story line appealing and its characters attractive, and we use them correctly when we terminate consideration of buying an automobile if we find it ugly.
Affect shortcuts lead us correctly, but affect errors mislead us. Investments, like automobiles and movies, exude affect, beautiful or ugly, attractive or repulsive. “Dot- com” names exuded positive affect during the dot- com boom of the late 1990s. Companies boosted their stocks’ prices by jettisoning mundane names, such as Computer Literacy Inc., and adopting dot- com names, such as a FatBrain.com. Dot- com names conveyed negative affect in the dot- com bust of the early 2000s, and companies boosted their stocks’ prices by jettisoning dot- com names.
LESSON 4: KNOW TRADE- OFFS AMONG WANTS AND BALANCE THEM
Automobile buyers balance their wants when choosing a Toyota or a Ferrari. They might assess the utilitarian benefits of a Toyota higher than those of a Ferrari, but they value its expressive and emotional benefits lower. Assessments of costs and benefits vary from person to person, however, and so does balance between wants. Some people derive substantial expressive and emotional benefits from a Ferrari, in high social status and exhilaration, but other people do not. Indeed, some are embarrassed to drive a Ferrari but proud to drive a Toyota. Moreover, some who want the expressive and emotional benefits of a Ferrari are nevertheless willing to trade them for the utilitarian benefits of a Toyota. The same is true when one is choosing investments, such as shares of Toyota or Ferrari.
One buyer of Ferrari shares balances his wants of the expressive and emotional benefits of a Ferrari automobile with the consolation of his wants in Ferrari shares. “I will never own a Ferrari [automobile], but I can own the stock!” But another potential buyer is unwilling to trade the utilitarian benefits of high stock returns for the expressive and emotional benefits of Ferrari shares, knowing that high P/ E ratios of shares might bring low future returns. “P/ E of 36? No thanks.”
Should you choose silver or white as the color of your next automobile? The intuitive System 1 and associated cognitive or emotional shortcuts are adequate for a choice when the consequences of the wrong choice are small and assessment by the reflective System 2 would not improve choice. The expressive and emotional benefits of driving a car with a pleasing color are likely large relative to utilitarian costs.
Should you choose a Ferrari or Toyota as your next automobile? The intuitive System 1 and its associated cognitive or emotional shortcuts are not adequate for this choice, because the consequences of the wrong choice are large. Consideration of expressive and emotional benefits might draw you closer to a Ferrari than to a Toyota, but you are wise to engage the reflective System 2 before you choose. Did you reflect on differences in safety and the cost of insurance? Did you take test drives long enough to determine differences in comfort, handling, and noise? Did you read Consumer Reports’ comparison of the two cars and its recommendations?
Behavioral portfolio theory guides us to portfolios on the behavioral-wants frontier of investments as it might guide us to automobiles on the behavioral- wants frontier of automobiles. In each case, behavioral portfolio theory prescribes choices that balance our wants best. The behavioral-wants frontier of investments reflects trade- offs between those such as high expected returns, low risk, great social responsibility, and high social status. But each portfolio on the behavioral-wants frontier provides the highest expected return for each level of risk, social responsibility, and
social status.
Behavioral life- cycle theory guides us toward saving and spending during our life cycles. The theory acknowledges conflicting wants, such as buying a Ferrari today or securing retirement income 40 years in the future, and prescribes tools for balancing spending and saving. These include personal tools such as self- control and public- policy tools such as nudging people into retirement savings plans or mandating retirement savings plans, as Social Security is mandated.
CONCLUSION
Behavioral finance is finance for normal people, like you and me. We do not go out of our way to be ignorant, and we do not go out of our way to commit cognitive and emotional errors. Instead, we do so on our way to the utilitarian, expressive, and emotional benefits we want, such as hope for riches and freedom from the fear of poverty, nurturing our children and families, being true to our values, gaining high social status, and playing games and winning.
This book offers behavioral finance as a unified structure that incorporates parts of standard finance, replaces others, and includes bridges between theory, evidence, and practice. The rational people of standard finance are easier to place into elegant models than the normal people of behavioral finance, but it is models that must conform to people, not the other way around. As Albert Einstein is reputed to have said, “If you’re out to describe the truth, leave elegance to the tailors.” Normal people are more complex than rational ones, yet normal people are who we are— often normal- ignorant, sometime normal- foolish, but always able to become normal- knowledgeable and increase the ratio of smart to foolish behavior.