INTERVIEW WITH MEIR STATMAN: “WHAT INVESTORS REALLY WANT”

I recently had the opportunity to interview Professor Meir Statman and discuss his new book entitled What Investors Really Want. In the book he wants the reader to learn the lessons of behavioral finance and discover what drives investor behavior so they can make smarter decisions. I was going to feature the audio of the interview but decided against it. Rather than have a 1 hour audio where the pertinent points are intertwined and lost in confusion, a focused question and answer with some references to applicable tales seems better.

For those not familiar with Meir Statman, he is the Glenn Klimek Professor of Finance at the Leavey School of Business in Santa Clara. His research on behavioral finance has won numerous awards and he has been published in the most prestigious of academic journals. If a Who’s Who in Behavioral Finance were to be published, his name would appear prominently. His insights are worth embracing. He’s devoted his research to the study of what makes people or investors do the things they do.

In terms of a book review, first and foremost—Prof. Statman’s book is for the regular investor. You don’t need a degree in mathematics or finance to get his meaning or find value from his wisdom. He has lots of stories you might relate with and offers practical ways to overcome negative behavioral tendencies. From the investment perspective, he tries to bridge the gap between Investment Return and Investor Return. This gap is created by poor behavior and though I wouldn’t want to put words in the Professor’s mouth if I can summarize I would say Prof. Statman believes that investment success is more a function of creating positive behavior modification rather than skill. Yet we all think otherwise. His point is that with a rudimentary knowledge of investing you can do better than most of your neighbors if you have good behavior. He believes this behavior can be learned as do I. At a minimum, it can be purchased for a reasonable fee if you find it impossible to bridge the behavioral gap.

So what’s the difference between Investment Return and Investor Return? Investment return is what the stock, fund, manager, ETF, etc. makes over a given time frame while Investor Return is what the average investor that owns the security makes during the same time frame. In the ideal world, if no one ever sells anything during the time frame, Investment Return equals Investor Return. However, the world is not ideal. Most people suffer significantly lower returns from doing something rather than from doing nothing. In this case, something is not better than nothing. This behavioral gap is what needs to be addressed and modified. With just a few basic skills Prof. Statman believes you can move to the very top or near the top of the investment success pyramid because you will avoid the mistakes that lower returns.
I know he thinks this to be true and easy but this is where I part ways with him.

I think it takes a special person to overcome these human frailties. The literature is filled with great minds and investors espousing a diversified portfolio of low cost index funds but few can actually execute the plan. While I agree with the likes of John Bogle, Charles Schwab, Warren Buffett, David Swenson, Meir Statman and the exhaustive list of diversification believers– they all assume the average investor is psychologically constructed like them. They are not. It’s the reason the average investor fails and the reason the behavioral gap exists. His book is a great place to access your frailties, understand your limitations and determine What Investors Really Want. Once you do you are on your way to bridging the gap. In this regard, I believe Prof. Statman is doing a great service to his readers.

In addition to my summary above, I submitted 2 specific questions in writing which he was very kind to answer. I have asked this question many times and get many different answers but I can say with certainty, these answers are unique and in line with my beliefs.

Q1: Should the typical investor manage their portfolio? If yes, should they manage the money actively or passively? If the answer is no, how can they differentiate one advisor from the next?

Answer

Think of a car analogy:

What car should a typical person buy? The answer depends on what our “typical investor” wants.

A car buyer who wants only the utilitarian benefits of a high ratio of quality to price should buy a Honda. But a car buyer who also wants the expressive and emotional benefits of a bit more prestige should buy an Acura. The Acura has lower utilitarian benefits but greater expressive and emotional benefits. The tradeoff is acceptable, even desirable, to some car buyers. A car buyer who wants the expressive and emotional benefits of social responsibility might pay extra for a Honda hybrid. A buyer who wants the thrill of driving would buy a Honda sports car.

The same is true for investors. Honda buyers buy low-cost index funds. Acura buyers buy hedge funds. Hybrid buyers buy socially responsible funds. Sports car buyers buy active funds.

No car is best for all and no investment strategy is best for all. Investors must know what they really want. This is why the title of my book is “What investors really want.”

Some buyers of socially responsible funds are willing to accept lower returns for social responsibility and admit it to themselves and perhaps to others. But few hedge fund investors are so candid with themselves or others about their desire for prestige. They say that an Acura has a higher quality-price ratio than a Honda and their hedge funds have a higher ratio of returns to risk than an index fund. Similarly, active fund buyers deny that they are looking for action, insisting that all they care about are returns.

I prefer index funds and Honda cars. I gain prestige from buying and displaying expensive oil paintings in my home. To each his own, but I don’t kid myself that a $4,000 painting is cheaper than a $20 poster which can cover even more of the wall than my painting.

I advise against hiring an advisor who promises higher returns. But I advise for hiring one if you need financial planning, education, and hand-holding to prevent you from doing stupid things, such as market timing. An advisor can help you overcome “get-even-itis” by “harvesting” losses, and can help you overcome the urge to realize gains and pay taxes on them.

Choose advisors who demonstrate real desire to know what you and your family want and need. Choose advisors who are good at managing investors, not only investments. Stay away from advisors who are frustrated hedge fund managers, more interested in investments than investors.

Q2: Of all the behavioral obstacles facing investors, you mention “get-even-itis” or the need to have your investment get back to break-even as one of the negative behavioral tendencies of investors. From my observations I also know that selling investments prematurely or not letting your winners run is also a negative tendency. What other errors contribute to the Investment Return vs. Investor Return Gap?

Top errors: To me, the top errors are not “get-even-it is” or haste in realizing gains but misunderstanding ourselves, investments and markets.

I spoke about misunderstanding ourselves before. As to misunderstanding investments and markets the biggest mistake is misunderstanding the negative-sum beat-the-market game. For those who understand the game but still play it the biggest mistakes are cognitive errors and emotions I discuss in the book, such as overconfidence and hindsight errors.

In closing, since this site is dedicated to financial literacy and my tales are meant to educate I ask the reader to refer to the following tales to gain insight to the answers by the wise professor.

A Tale of Diversification—-In this tale we explain the fundamental choice investors must make. They can choose to diversify or not. Prof. Statman has chosen to diversify and use passive investments. He in fact mentioned his personal portfolio is invested at Vanguard and he seldom trades it and has no problems when the portfolio either drops significantly or rises significantly. He just sticks to his plan. He believes that over time since he selects broad based quality index funds he will make a return that is suitable for his needs and he can focus his efforts in other areas that give him more pleasure. He understands himself. This is what he means when he says he prefers to buy a Honda instead of an Accura, a Hybrid or a Sports Car. He also understand that others have different preferences so you need to understand yourself.

A Tale of Identity
In this tale I explain the three types of investors which I call the Diversifier, the Trader and the Selector. If you decide after reading A Tale of Diversification that diversification is not for you then you will fall into the category of either a Trader or a Selector. If this is the case, superior trading skill or investment selection skill is required to outperform the Diversifier. Most people fail miserably in their pursuit to do better than the Diversifier. This is the reason so many smart and successful investors recommend diversification.

A Tale of Duty
In this tale I explain what the value of an advisor is to the client that chooses to diversify yet in my opinion is for the most part ill-equipped due to the behavioral gap. It explains that while the client perceives the advisor’s value is investment skill in reality it is the advisor’s skill in dealing with investors and their behavior. This is what Prof. Statman means when he says that people should hire advisors that are good at ”managing investors not only investments.”

A Two Timing Tale
This tale brings it all together. I call it the No Man and it speaks to the role of advisor. The conclusion of this tale is that if the only thing an advisor did is prevent the client from market timing, they would more than justify their fee.

Let me know what you think and enjoy.

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