What Investors Really Want
Lessons from Behavioral Finance
Meir Statman
Glenn Klimek Professor of Finance
Santa Clara University
What Investors Really Want
Utilitarian, Expressive, and Emotional Benefits
The difference between:
1. Giving a rose to a
woman you court
2. Giving her $10, the
price of a rose
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What watch-buyers really want
Why do I pay $10,000 for an IWC watch?
Utilitarian benefits
What does it do for me and my
pocketbook?
It tells time and never breaks down
Expressive benefits
What does it say about me (to me and to
others)?
I am a successful man with high status
and refined tastes
Emotional benefits
How does it make me feel?
Accomplished and masculine
What Investors Really Want
We want to stay true to our values
Socially responsible
investments
Utilitarian benefits
I’ll get high returns
Expressive benefits
I am socially responsible
Emotional benefits
I have peace of mind because my
finances are true to my values
2
What Investors Really Want
We want high status and proper respect
Hedge funds
Hedge-fund money can put you into
exhilarating conversations about the
virtues of Gulfstreams versus Falcons
Utilitarian benefits
I will have high returns with low risk
Expressive benefits
I have high status
Emotional benefit
I feel proud as a member of an exclusive
club
What Investors Really Want
We want great beauty and high status
Kenneth Griffin of Citadel bought Jasper Meir Statman painted “Colors in Straight
Jones’ “False Start” for $80 million Lines” $50 canvass and $20 paint
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What Investors Really Want
What do we want?
Why do we invest in socially responsible funds?
Why do we invest in hedge funds?
Why do we listen to TV gurus?
What Investors Really Want
Wants and cognitive errors
What do we want?
To get high returns (What is the money for?)
To nurture our families
To banish fear of poverty
To savor hope for riches
To play the beat-the-market game and win
4
What Investors Really Want
What Institutional Investors Really Want
To get high alpha?
To play the beat-the-market game and win?
What Investors Really Want
We want to play and win
Benefits to ‘active’
investors
Utilitarian benefits
It provides high returns
Expressive benefits
I am much smarter than
mediocre index fund
investors
Emotional benefits
I love the exhilaration of
winning
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First Lesson
Know Yourself
Know Your Clients
Know Your Competitors
Know their wants
Know their goals
Know their cognitive errors
Know their emotions
Second Lesson
Know Science
Teach science to your clients
Teach the science of financial markets
Teach the science of human behavior
Apply science to public policy
Knowledge through science distinguish
institutional investors from
individual investors
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Second Lesson
Know Science and teach science
The tools of science
“System 1” is the Intuitive (Blink) system
System 1 is automatic, effortless, rapid, and skilled
(An American in the US, driving on the right)
“System 2” is the Scientific (Think) system
System 2 is controlled, effortful, slow, and rule- following
(An American in the UK, driving on the left)
Know the science of human behavior
and teach it
Why is it hard to resist intuition,
even when it is wrong?
John Nash - A Beautiful Mind
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Why do we behave as we do?
Behavioral Finance version 1 Behavioral Finance version 2
Because we are normal,
pursuing what normal
investors want
Because we are irrational
We fall victim to cognitive
errors and misleading
emotions on our way
to what we want
Foundation blocks of standard finance
1. Investors are rational
2. Investors should construct portfolios by the rules of mean-
variance portfolio theory (and actually do so)
Investors save and spend by life-cycle theory (Smoothing
spending over the life-cycle)
3. Markets are efficient
4. Expected returns are determined only by risk (measured by
beta)
(Only utilitarian factors)
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Foundation blocks of behavioral finance
1. Investors are normal
2. Investors construct portfolios by the rules of behavioral
portfolio theory (and are wise to do so)
Investors save and spend by behavioral life-cycle theory
(Affected by framing, mental accounting and imperfect self-
control)
3. Markets are not efficient (but are not as easy to beat as
many normal investors think)
4. Expected returns are determined by more than risk
(Utilitarian, expressive and emotional factors)
Know the science of human behavior
and teach it
Why do we behave as we do?
Fear is a normal emotion - Usually a useful emotion
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The Shining
Know the science of human behavior
and teach it
Fear can be a misleading emotion
Do you think that now is a good time to invest in the financial markets?
Percentage of investors who said Yes
Percent
90
10,938
Feb-
Feb-00 78%
13,366
Dec-
Dec-07 55%
60
Mar-
Mar-03 41%
7,890
30
0
Feb-99 May-00 Aug-01 Nov-02 Feb-04 May-05 Aug-06 Nov-07
Source: UBS Index of
Investor Optimism
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Know the science of human behavior
and teach it
Why do we behave as we do?
Why do we believe
that it is easy to beat the market?
Cognitive errors
Framing errors
Overconfidence errors
Confirmation errors
Herding errors
Know the science of human behavior
and teach it
Framing errors
I sell my stocks because
stocks are sure to go down!
Who is the idiot who is buying my stocks?
Framing the trading game as tennis
against Roger Federer
(or Goldman Sachs, or high frequency traders,
or Raj Rajaratnam)
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Know the science of human behavior
and teach it
Overconfidence errors
On average, we are above average
18
Return investors expect from their own portfolio
16
14
12
10
Return
8
Return investors expect from the stock market
6
0
Apr-99
Jun-99
Aug-99
Oct-99
Dec-99
Feb-00
Apr-00
Jun-00
Aug-00
Oct-00
Dec-00
Feb-01
Apr-01
Jun-01
Aug-01
Oct-01
Dec-01
Feb-02
End of 6-month moving average
Source: UBS Index of Investor Optimism
Know the science of human behavior
and teach it
Confirmation errors
We look for evidence that confirms our
claims and beliefs
We overlook evidence that disconfirms
them
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Know the science of human behavior
and teach it
Confirmation errors
Claim: ‘The severity of the current crisis was
obvious to anyone who cared to look’
Confirming evidence: Nouriel Roubini saw it
Disconfirming evidence: Ben Bernanke and
countless other equally good experts did not
Know the science of human behavior
and teach it
Confirmation errors
Nouriel Roubini in February 2010,
when the S&P 500 Index was at 1,063
Forecasting the level of the S&P 500
Index at the end of 2010
The S&P 500 Index ended 2010 at 1,258
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Know Science
Confirmation errors
March 9, 2009
Jeff Kearns - Bloomberg
The S&P 500 was at 677
Roubini said:
“My main scenario is that it’s highly likely it goes to
600 or below”
A level of “500 is less likely, but
there is some possibility you get there”
Know the science of human behavior
and teach it
Herding errors
Herding can be beneficial
Herding can be harmful
How can we tell the difference?
What information drives this herd?
What benefit or harm can come from joining this herd?
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Know the science of human behavior
and teach it
Restaurant Herd
Question
If you could increase your chances of
having a more comfortable retirement
by taking more risk, would you:
a. Be willing to take a little more risk with
all your money?
b. Be willing to take a lot more risk with
some of your money?
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If you could increase you chances of
improving your returns by taking more
risk, would you:
Risk Money
a. A little
x All of your
= Addition to
more risk money portfolio risk
b. A lot more Some of Addition to
risk x your money = portfolio risk
What do investors want?
Freedom from fear – Downside protection
Hope – Upside potential
Goal-based portfolios
We want to be rich
(10% chance to be rich)
We don’t want to be poor
(Almost 100% chance not to be poor)
16
Combining elements of
mean-variance portfolio theory
and behavioral portfolio theory into
a mental-accounting portfolio framework
Portfolio Optimization With Mental Accounts,
Journal of Financial and Quantitative Analysis, 2010
Portfolios for investors who want to reach their
goals while staying on the mean-variance
efficient frontier
Journal of Wealth management, 2011
Das, Markowitz, Scheid, and Statman
The overall portfolio and mental account (goals) sub-
portfolios are all on the mean variance efficient frontier
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Question
Think about switching your portfolio
You have a 50-50 chance to increase your standard of living by 50%
throughout your life
You have a 50-50 chance to decrease your standard of living by X%
throughout your life
What is the maximum X% you are willing to accept?
1. 10% or less
2. 11-20%
3. 21-30%
4. More than 30%
Question
Who (on average) are more loss averse?
1. Dutch
2. Vietnamese
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Loss Aversion
Loss Aversion in the Domain of Portfolios
4.5
3.5
2.5
1.5
0.5
2.93 4.19 4.00 4.03 3.58 3.97
0
China France Italy Japan Poland US
Countries where loss aversion is high tend to be
countries where uncertainty avoidance is high
Uncertainty Avoidance Index (UAI)
100
90
80
70
60
50
40
30
20
10
40 86 75 92 93 46
0
China France Italy Japan Poland US
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Question
Do you think that:
1. Incomes should be made more equal
or
2. We need larger income differences as
incentives
Counties where uncertainty avoidance is high tend to be
countries where preference for equal income is high
Preference for Equal Income
7
1
4.94 5.92 5.06 5.24 4.41 4.94
0
China France Italy Japan Poland US
20
Counties where uncertainty avoidance is high tend to be
countries where social spending is high
Social Spending
35
30
25
20
15
10
5
NA 29.7 24.7 18.7 19.7 16.3
0
China France Italy Japan Poland US
What Investors Really Want
Why do we put money in our portfolios?
What will we do with it?
Utilitarian benefits
I have money for retirement
Expressive benefits
I am financially independent
Emotional benefits
I have freedom from fear
(Downside protection)
I have hope for riches
(Upside potential)
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What Investors Really Want
We want a dignified retirement life
Problem:
Many do not save enough for retirement
Reasons:
- Inability to earn enough for spending and savings
- Inability to properly allocate earnings to
spending and savings
What Investors Really Want
We Want to Save for Tomorrow
and Spend it Today
The Problem of Self-Control
Save for Tomorrow Spend it Today
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What Investors Really Want
We Want to Save for Tomorrow
and Spend it Today
The benefits and difficulties of self-control
Genetics account for one-third of differences in
saving behavior
Self-control is associated with conscientiousness
(One of the Big-Five factors of personality)
Conscientious people tend to excel academically
and at jobs, have stable marriages, and live long
Conscientious people do not buy things on impulse
What Investors really Want
We want retirement savings protected from weak self-control
Retirement savings in the old mandatory DB paternalistic days
Voluntary
Savings
(Libertarian)
Mandatory Defined Benefits (DB)
Retirement Savings
(Paternalistic)
Social Security
(Paternalistic)
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What Investors Really Want
We Want Fairness
Politics make defined-benefit pensions impossible
Detroit Spent Billions Extra on Pensions
What Investors Really Want
We Want Fairness
Insider Trading
Workers’ Rights
(Raj Rajaratnam)
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What Investors Really Want
We Want Fairness
What does fairness mean?
Fairness rights
Libertarian fairness right –
Freedom from coercion
Liberal (socialist) fairness right –
Equal power
Paternalistic fairness right –
Freedom from cognitive errors and
misleading emotions
What Investors Really Want
We Want Fairness
Perceptions of fairness and choice of fairness rights
Motivated by ideology and self interest
Unions negotiating with corporations compare their
salaries to salaries in higher-paying companies
Corporations compare the salaries the pay to
salaries in lower-paying companies
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What Investors Really Want
We Want Fairness
Perceptions of fairness and choice of fairness rights
Motivated by ideology and self interest
An elderly man complained about applying “chained
Consumer Price Index” to Social Security benefits
“Why don’t you put that chain on Government spending?”
Social Security and Medicare make up 60% of
Government spending
What Investors really Want
We want retirement savings protected from weak self-control
Retirement savings in the early voluntary libertarian DC days
Voluntary
Savings
(Libertarian)
Voluntary Defined Contribution (DC)
Retirement Savings
(Libertarian)
Social Security
(Paternalistic)
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What Investors really Want
We want retirement savings protected from weak self-control
Retirement savings in the more recent voluntary
libertarian-paternalistic (Nudge) DC days
Voluntary
Savings
(Libertarian)
Voluntary Defined Contribution (DC)
Retirement Savings – With a Nudge
(Libertarian - Paternalistic)
Social Security
(Paternalistic)
What Investors really Want
We want retirement savings protected from weak self-control
Retirement savings in my proposed
mandatory paternalistic (Shove) DC days
Voluntary
Savings
(Libertarian)
Mandatory Defined Contribution (DC)
Retirement Savings – With a Shove
(Paternalistic)
Social Security
(Paternalistic)
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What Investors really Want
We want retirement savings protected from weak self-control
Retirement savings in my proposed
mandatory paternalistic (Shove) DC plan
1. Combined mandatory contributions by employers and
employees amounting to a minimum of 12% of earnings
2. Administration by companies offering DC plans but with a
central agency for employees whose companies do not
provide DC plans
3. Default offerings of well-diversified target-date funds set in
one-year intervals
What Investors really Want
We want retirement savings protected from weak self-control
Retirement savings in my proposed
mandatory paternalistic (Shove) DC plan
4. Fees not exceeding 30 bps
5. No borrowing from retirement savings accounts and no
cashing out of accounts before retirement age
6. Enhanced financial literacy through education at high
schools and elsewhere
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Conclusion
First Lesson
Know yourself
Know your clients
Utilitarian, expressive and emotional benefits
Second Lesson
Know Science
Teach science to your clients
Apply science to public policy
References
• M. Statman, “What Investors Really Want,” McGraw-Hill, 2011
• S. Das, H. Markowitz, J. Scheid, and M. Statman, “Portfolio optimization with mental accounts,” Journal of
Financial and Quantitative Analysis, 2010
• S. Das, H. Markowitz, J. Scheid, and M. Statman, “Portfolios for investors who want to reach their goals
while staying on the mean-variance efficient frontier,” Journal of Wealth management, 2011
• M. Statman, “Efficient markets in crisis, “Journal of Investment Management, 2011
• M. Statman, “What is Behavioral Finance,” in Behavioral Finance and Investment Management, edited by
Arnold Wood, Research Foundation Publications, CFA Institute 2010
• M. Statman, “Culture in loss-aversion, income inequality, and safety nets
• M. Statman, “Mandatory retirement savings,” Financial Analysts Journal, 2013
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Meir Statman
Contact Information
Meir Statman
Glenn Klimek Professor of Finance, Santa Clara University
500 El Camino Real, Santa Clara, CA 95053, USA
Tel 408 554 4147
mstatman@[Link]
[Link]
[Link]
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