Advice for Investors — A Q&A with Meir Statman

November 2013

Portfolio Perspectives

What is behavioral finance?Behavioral Finance is the study of the behavior of normal investors, people like me, people like you. We are normal smart most of the time but sometimes we are normal stupid. It is also about how our behavior is reflected in financial markets and about how to improve the behavior of investors. Once we understand the cognitive errors that befall us, once we understand the emotions that are natural to us, we can counter them where they lead us astray. And this is one of the joys of being on the committee at Loring Ward because I get to participate in this great enterprise of trying to help investors do the right thing.

What is the most significant change you’ve seen in the area of finance that impacted the way that investors invest?

What I see is the move from what we know as defined benefits (pension plans) to defined contributions. It used to be that people did not have to worry about retirement. They got a job that had a pension attached to it and they knew that someday they were going to get a portion of their pay throughout their lives. That is gone. That has been replaced by 401(k)s and IRAs. This means that people must know more about finance than ever.

In your opinion, how can investors use behavioral finance to have a better investment experience?

Investors who know their cognitive errors and emotions can create defenses against them when they lead them the wrong way. For example, why do people trade so much when the facts show that people who trade the most lose the most? It’s because people think of trading like playing tennis against a training wall. But tennis is not played against a wall; it is played against an opponent on the other side. And in trad-ing, that opponent might be Warren Buffet. Once investors realize that they have to ask themselves, “Who’s the idiot on the other side of the trade?” they might conclude that they are the idiot and stop trading.

If we can get people to pause, to learn about themselves, and learn to avoid the mistakes, we can do better. Our own retire-ment, helping our children, contributing to charity…all of these are more important than wasting our money on trading.

How should “normal” investors invest their money?Well, before they get to invest their money they have to make their money. Next we can create systems that will help us save. For example, if money goes straight from our paycheck into a 401(k) we don’t have to think about whether we want to save it or spend it. Once we have saved, then the question

We recently sat down with Meir Statman to talk about the role our emotions play in how we make decisions and how that information can affect investors. Meir, a behavioral finance expert, is the Glenn Klimek Professor of Finance at Santa Clara University and a member of the Loring Ward Investment Committee. His research has been published in the Journal of Finance, the Journal of Financial Economics, the Review of Financial Studies, the Journal of Financial and Quantitative Analysis, the Financial Analysts Journal, the Journal of Portfolio Management, and many other journals. Meir received his Ph.D. from Columbia University and his B.A. and M.B.A. from the Hebrew University of Jerusalem. Statman

Portfolio Perspectives

is, how can we conserve and grow it so much that it is suf-ficient for us in life and retirement? It is really important for all investors to have well diversified portfolios that include stocks, that include bonds, that include real estate, that include other assets that are going to create a balanced port-folio with relatively low risk relative to the returns. And if we just maintain it, history has shown we are going to do much better than if we try to play around with it, manage it, get it in the hands of active investors, etc.1

How do our emotions affect our investing?Some people say you have to take emotions out of investing. But you really cannot do that because emotions are in all of us and generally emotions do us well. But sometimes emotions can be exaggerated and mislead us. For example, surely 2008 and early 2009 were scary and that fear is still with us but what it caused some people to do is to sell all their stocks in early 2009, and they’re still afraid and so they would not put the money back in even though the stock market has pretty much recovered. Now they also have to deal with this emo-tional regret. If they put their money in today, after they’ve taken it out at a much lower level in the stock market, they’re going to feel like idiots. So they’re waiting for the market to go back to its level in early 2009 before they put the money in and they get themselves in loops that do them no good.

And so what is important is to realize that we have these emotions in us. We have exuberance. We have hope. We have regret. We have fear. All of those emotions can be useful to us but sometimes they are not. One of the things we try to do in behavioral finance is to make those distinctions; to find, for example, that in times when people are still fearful, you’ve got to expect both lower returns and high risk and use science to confront that.

How can investors manage their emotions?The first line of defense is internal. If you know that you are fearful, step away from yourself and ask whether that fear has good reason. We know from science that fear is often exaggerated and you should not act on it. Financial advisors

are a second line of defense because they work as educators. An investor, a client, would come to them and say, “I’m really scared of this market. This idea of ‘for the long run’ really does not work for me because I’m just too scared. I want to get all of my money out of stocks.” To the extent that advisors can explain what science shows, how emotions work, and then persuade investors not to act rashly, then advisors have done a great service to their clients.

Research shows that over confidence is a major investor error. Can you explain it?

Over confidence is a major cognitive error with an emotional component to it. Some investors know that trading is like playing tennis against an opponent. But somehow they’re over confident in their ability and so they say, “It is one of the Williams sisters on the other side of the net, but you know I’ve never played her. It might be that she will win and it might be that I will win. I’m going to wager $10,000 on it.” Of course that is stupid but that really is what over confi-dence does to us. You can trade and by luck you may make money, and you’ll think that that is evidence that you are a genius. Next time you’re going to put even more money into it and you’re going to lose. Over confidence is useful for us in many settings but not in investments.

How do you invest?Last year I was speaking at a conference and was asked, how do you invest? And I said, I invest exclusively in index funds and passive asset class funds. Afterwards, one of the people came to me and he said, “Here you are, somebody who knows a lot about finance, and you invest in index funds and passive class funds. Why?” And I said I invest in index funds because I know a lot about finance, because I know the science of finance and because science tells me that I will probably get better results in terms of risk and return by investing in a well diversified portfolio composed of index funds. The less you play with it, the better off you are. The less you manage it, the better off you are. Keep your investments simple so you can spend your time doing actual work and enjoying your family.

1Fisher, Kenneth L. and Meir Statman (2000), “Investor Sentiment and Stock Returns”, Financial Analysts Journal, 56 (2), pp. 16-23. Diversification neither assures a profit nor guarantees against loss in a declining market.Bonds are subject to market and interest rate risk. Bond values will decline as interest rates rise, issuer’s creditworthiness declines, and are subject to availability and changes in price.Stock investing involves risks, including increased volatility (up and down movement in the value of your assets) and loss of principal. Real estate securities funds are subject to changes in economic conditions, credit risk and interest rate fluctuations.© 2013 LWI Financial Inc. All rights reserved. LWI Financial Inc. (“Loring Ward”) is an investment adviser registered with the Securities and Exchange Commission. Securities transactions are offered through its affiliate, Loring Ward Securities Inc., member FINRA/SIPC. R 13-380 (Exp 10/15)