Journal of Financial Planning: May 2018
Meir Statman, Ph.D., is the Glenn Klimek Professor of Finance at Santa Clara University's Leavy School of Business and author of Finance for Normal People: How Investors and Markets Behave.
We often hear that behavioral finance is nothing more than a collection of stories about irrational people misled by cognitive and emotional errors; that it lacks the unified structure of standard finance. We are asked, what is your portfolio theory? What is your asset pricing theory? Yet today’s standard finance is no longer unified because wide cracks have opened between its theory and the evidence.
Behavioral finance, like all fields of knowledge, is a work in progress. The first generation of behavioral finance, starting in the early 1980s, attempted to fill the cracks in standard finance largely by accepting its notions of investors’ wants as “rational” wants for utilitarian benefits, such as those of high returns and low risk, yet describing investors as “irrational,” misled by cognitive and emotional errors on the way to their rational wants.
In my 2017 book, Finance for Normal People, I presented the second generation of behavioral finance that describes investors, and people more generally, as “normal,” and offers behavioral finance as a unified structure that incorporates parts of standard finance, replaces others, and includes bridges between theory, evidence, and practice.
Distinguishing Wants from Errors
Our brains (the brains of “normal” people) are often full, unlike the brains of the “rational” people of standard finance. Our brains are like the brain of the student in the cartoon who raises his hand and asks, “May I be excused? My brain is full.” We are susceptible to cognitive errors such as hindsight errors that mislead us into concluding that we can see the future in foresight as clearly as we see the past in hindsight, and confirmation errors that mislead us into looking for evidence confirming our views and overlooking disconfirming evidence. And we are susceptible to emotional errors such as exaggerated fear and unrealistic hope.
We, normal people, do not go out of our way to commit cognitive or emotional errors. Instead, we do so on our way to the benefits that come when we satisfy our wants—hope for riches and freedom from the fear of poverty, nurturing children and families, being true to values, gaining high social status, playing games and winning, and more.
The second generation of behavioral finance distinguishes wants from errors, and offers guidance on using shortcuts and avoiding errors on the way to satisfying wants. People’s wants, even more than their cognitive and emotional shortcuts and errors, underlie answers to important questions of finance, including people’s behavior, portfolio construction, life cycle of saving and spending, asset pricing, and market efficiency.
Standard finance is built on five foundation blocks:
- People are rational.
- People construct portfolios as described by mean-variance portfolio theory, where people’s portfolio wants include only high expected returns and low risk.
- People save and spend as described by standard life-cycle theory, where people find it easy to find and follow the right way to save and spend.
- Expected returns of investments are accounted for by standard asset pricing theory, where differences in expected returns are determined only by differences in risk.
- Markets are efficient, in the sense that prices equal values in them and in the sense that they are hard to beat.
Behavioral finance offers an alternative foundation block for each of the five foundation blocks of standard finance, incorporating knowledge about people’s wants and their cognitive and emotional shortcuts and errors. According to behavioral finance:
- People are normal.
- People construct portfolios as described by behavioral portfolio theory, where people’s portfolio wants extend beyond high expected returns and low risk, such as for social responsibility and social status.
- People save and spend as described by behavioral life-cycle theory, where impediments, such as weak self-control, make it difficult to find and follow the right way to save and spend.
- Expected returns of investments are accounted for by behavioral asset pricing theory, where differences in expected returns are determined by more than differences in risk, such as by levels of social responsibility and social status.
- Markets are not efficient in the sense that prices equal values in them, but they are efficient in the sense that they hard to beat.
Transition from Standard Finance to Behavioral Finance 2.0
My own transition illustrates the on-going general transition in finance. I was a student at the Hebrew University in Jerusalem in the late 1960s, in a building housing the economics and finance faculty. Daniel Kahneman and Amos Tversky were doing their pioneering work on cognitive shortcuts and errors in the building right next to mine, housing the psychology faculty. Yet I had no idea who Kahneman and Tversky were, and none of my economics and finance professors mentioned their names or referred to their work. It was the time of standard economics and finance.
I came to New York in late August 1973 to study for the Ph.D. at the Graduate School of Business of Columbia University. The October 1973 Yom Kippur War and subsequent energy crisis caught me by as much surprise as it caught the long lines of drivers hoping that gas pumps would not run dry before they reached them.
“Stockholders and Pickets Score Con Ed Management,” was the headline of an article in The New York Times on May 21, 1974. Above the headline was a photograph of a packed Commodore Hotel ballroom. More than 4,000 Consolidated Edison shareholders overflowed the ballroom into two auxiliary suites, leaving many shareholders outside, including Sydell Pflaum, a 76-year-old widow who relied on her $90 Con Ed quarterly dividend for precious financial support.
The May 1974 Con Ed shareholder meeting was the first since its announcement the month before that it was suspending its quarterly dividend—something it had never done since it started paying dividends in 1885. Con Ed attributed its decision to an urgent need to conserve cash reserves severely depleted by soaring fuel prices in the wake of the Arab oil embargo. But Con Ed’s reasoning did not sway Ms. Pflaum.
Fuming with anger, Ms. Pflaum paid $189 to fly from Miami Beach to New York for the Con Ed meeting. “Where is Luce? Since I can’t get in, maybe he’ll at least pay my way back home,” she said, referring to Charles F. Luce, the utility’s chairman.
I remember being struck by the fury of the shareholders at the Con Ed meeting. I knew that the behavior of Con Ed’s shareholders contradicted standard financial theory. In my finance courses at the Hebrew University we studied an article by Merton Miller and Franco Modigliani that proved rational investors do not care about dividends. Rational investors who expected company-paid dividends but did not receive them can substitute for them “homemade” dividends created by selling as many shares of stock as necessary to yield the same amount.
Why then were Con Ed’s shareholders fuming when they did not receive their dividends? This is what Fischer Black called “The Dividend Puzzle” in a 1976 article in the Journal of Portfolio Management. “Why do corporations pay dividends? Why do investors pay attention to dividends? ...The harder we look at the dividend picture, the more it seems like a puzzle, with pieces that just don’t fit together,” he wrote in that article.
I joined Santa Clara University at the end of 1979 and some months later heard Hersh Shefrin speak about joint work with Richard Thaler on framing, mental accounting, and self-control and their relation to savings behavior. Richard Thaler is the 2017 Economics Nobel Laureate, but in 1979 he must have been wondering if he would ever get tenure.
I could see the link to the divided puzzle. Normal investors with imperfect self-control are concerned that they might give in to temptation and turn a 3 percent homemade dividend into a 30 percent homemade dividend. They bolster their self-control by framing their money into separate mental accounts, one for income and one for capital, and use the rule, “spend income but don’t dip into capital,” to prevent spending too much and saving too little. Rational investors have perfect self-control obviating any need for framing, mental accounting, and spending rules.
It turned out that Shefrin was thinking along the same lines and we decided to collaborate. We offered a solution to the dividend puzzle built on framing, mental accounting, self-control, regret aversion, and prospect theory. We submitted our paper to the leading Journal of Financial Economics in early 1982. We used Fischer Black’s dividends puzzle article as a platform for our discussion and found out later that he was our article’s reviewer. Black’s review opening words still make me blush. “This paper is brilliant. It rings both new and true in my ears.” William Schwert, the editor, accepted Black’s recommendation after “some non-trivial soul-searching.” Much later we found that many of the journal’s associate editors objected vociferously to the paper’s publication, and some threatened never to submit any paper to the journal if our paper was published. That surely was the time of standard finance.
Black was elected president of the American Finance Association (AFA) and planned its December 1984 meeting. Shefrin and I offered to organize a session at the meeting, and he accepted. The session included our paper, “The Disposition to Sell Winners Too Early and Ride Losers Too Long: Theory and Evidence” and Werner De Bondt and Richard Thaler’s paper “Does the Stock Market Overreact?” Black chose to publish both papers in the Journal of Finance in 1985.
Peter Bernstein accepted my invitation to serve as the discussant of De Bondt and Thaler’s paper at the December 1984 meeting, and I accepted Peter’s invitation to serve as a discussant in a session he organized. I ended my discussion of that paper with what Shefrin called “a manifesto.” I said “Finance is full of puzzles and it seems as if one is added every day. It is clear, as stated by William Schwert, that we need new theory. However, unlike Schwert, I see no reason why this new theory must be consistent with rational maximizing behavior on the part of all actors in the model. We should develop descriptive (positive) theories. If evidence shows that models allowing actors to display cognitive biases and changing perceptions explain the world of finance better than models allowing only rational behavior, so be it.”
Lessons for Planners
The second generation of behavioral finance offers many lessons to financial planners, some old and some new. One lesson rooted in understanding normal people is to begin by probing clients’ wants and proceed by helping them satisfy wants while avoiding cognitive and emotional errors. Some clients want to combine wants for wealth with wants for staying true to values, whether protecting the environment or adhering to religion. Many refuse to maximize wealth first, and then use it to satisfy wants of staying true to values. Planners do well to build portfolios that satisfy clients’ wants for staying true to values while minimizing injuries to clients’ wealth.
A lesson rooted in behavioral portfolios is to build portfolios as pyramids of mental accounts, each associated with a want, whether retirement income or education for children and grandchildren, and perceive and explain risk as shortfall from wants, not as volatility or losses. Treasury bills impose no volatility or losses, but they pretty much guarantee shortfalls from even modest wants for retirement income.
A lesson rooted in behavioral life cycle is to help young clients adhere to rules that facilitate saving and retirement wealth, and help well-off retirees adhere to rules that facilitate spending, including dipping into wealth and giving with a warm hand rather than with a cold one.
A lesson rooted in behavioral asset pricing is know that investments are products and services, no different from cars and restaurant meals. The price of a car depends on more than the size of its engine, the price of a restaurant meal depends on more than its calories, and the price and expected returns of an investment depends on more than its risk.
And a lesson rooted in behavioral efficient markets is to know the difference between price-equals-value markets where bubbles are impossible, and hard-to-beat markets where bubbles are possible but hard to identify in time, and dissuade clients from jumping too fast from the fact that bubbles occur to the conclusion that they can identify them in time. In other words, markets may be crazy, but this does not make you a psychiatrist.