What Investors Really Want: Discover What Drives Investor Behaviour and Makes Smarter Financial Decisions

Citation

Forbes, W. (2011), "What Investors Really Want: Discover What Drives Investor Behaviour and Makes Smarter Financial Decisions", Qualitative Research in Financial Markets, Vol. 3 No. 3, pp. 243-248. https://doi.org/10.1108/17554171111176930

We have it on good authority that no man can serve god and money. But we must be grateful to Professor Statman for pointing out that achieving our financial goals alone can bring about intense internal conflicts within us generating feelings of elation, regret, personal failure and loss (Statman, 2011). This is because the investment process brings out so many competing desires and needs to within us. It is certainly true that we seek to maximise wealth given limited resources at our disposal, but we do seek so much else besides. We also look to investments to express ourselves and find emotional fulfilment. Investment choices thus reflect financial, expressive and emotional motivations and the reductive reasoning of standard finance can mislead us in this regard. Ultimately, in our investments as in our lives we want it all and this book cautions us about the dangers of that quest.

All this should not surprise us. Most of us seek a job with a decent salary. But once salary offers reach some acceptable level we differentiate between offers on closeness to family, friendliness of prospective colleagues, etc. Why should selecting between investments be guided by mechanisms very different than choosing our job? After all the financial consequences of job choices most probably exceed most investment decisions. The book's title bears the prefix “lessons of behavioural finance” and it surely provides a very palatable, easily read, guide to that research field with insights from one of the pioneering and still leading researchers in it. By investing we meet others like ourselves with shared aspirations fears and hopes, we share our lives but we also square up, compete and seek superiority over them. In short investment reveals our flawed humanity in much the same way as dietary, dental care, or choice of partner, and friends does. Statman explores these contradictions by outlining a number of binary oppositions and their associated resolution mechanisms, a desire for high return and low risk, to conform to other's expectations of us and yet shine as a star, we want to be morally upright while maintaining, or ideally enhancing, our wealth. I do not explore all these tensions and desires here but rather give a flavour of the wide terrain covered in this book.

One tension standard finance stresses, almost to the exclusion of all others is that between risk and return. Statman points out even those who believe stock markets are “irrational”, valuing equities in contradiction of the future cash‐flows they offer, are not safe in concluding markets are beatable in any consistent way. To know someone behaves unwisely does not help me predict their next stupid action necessarily. Investors understand that risk and return must be traded off but cannot withstand the allure of a consistently high‐return stock, even if they need to muffle alarm bells when buying them. Rather investors seem to divide stocks into great buys with prospective high return and low risks and must sells with prospective low returns and high risk. The victims of Bernie Madoff were gulled by a irresistible stream of largish profits. The hook for them was not so much huge profits but rather the elimination of losses. Crucially for many of Madoff's investors he was “one of them”, a Jew, and a very respected, lauded, Jew at that. Madoff created a sense of identity in his victims and perhaps a sense of entitlement or deservedness. In the same way as buying a house or car expresses our notion of who we are and aspire to be our investment portfolio does the same thing. Investing is as much a social process as joining a gym or becoming theatre season ticket holder. Indeed, such virtual communities are on web sites such as Mint and Wesabe are proliferating apace. Investors know active trading is most probably a sure way to lose money unless you have inside information, a stroke of genius or are just plain lucky. So why do they do trade so much?

One reason we trade, despite the clear evidence supporting passive investment is our desire to find patterns in stock market data, to impose order on a seemingly chaotic world. The representativeness heuristic pushes us to predict a distribution of outcomes in alignment with our impressions of past data. In this struggle, extraordinary successes often outweigh silent disasters not least because of the tendency of professional investors to shout about gains and quietly endure losses. One group of winners who have no incentive to boast are insiders with access to specific knowledge. While in developed markets regulation constrains insider profits it is unlikely to eliminate them entirely. In the expanding markets of China and Russia, insider trading is almost accepted as a tax on the gullible. So for the ordinary investor the hope of beating the market can seen as almost delusional. Hindsight allows us to rationalise losses as unpreventable, while basking in the glory of how brilliant trading strategy made us rich. But another reason is that we choose investments not just with our minds but also with our hearts.

Perhaps, the best documented emotional trait affecting decision making is optimism. Most of us simply believe our lives will be better, more fulfilled and happier than they ultimately turn out to be. The reason few of us bother to correct this character fault is simple. It is simply an error of judgement that is pleasant to have. Optimists socialise better, seem happier, recover from surgery and bad experiences, like divorce, more speedily. So optimism may make us poorer investors but it also makes us happier, better, people. Our lives as investor cannot simply be torn apart from our normal everyday lives, nor would attempting to do so be of clear benefit to us. So trading volumes rise in rising markets and fall as fear takes grip in falling markets. Professional investors know this well and exploit the cycle of fear and hope to their advantage.

Herding in our investment choices may seem mindless idiocy but the broad tendency to conform in language, dress and body language can be very useful to me. While being a huggie sort of guy might be endearing with my theatre‐going friends, it may alarm my Muslim friend's wife. Conformity has value and simply shedding such inhibitions would not be costless or even desirable. Even Nobel Prize winners, like the partners of Long‐Term Capital Management can be swept up by hopes of huge riches, taking on huge personal loans to allow them lever up their personal stakes in the fund. For less gifted investors participation in the market retains much of the character of a “game” offering all the thrills and spills of any sport, both its glorious heroes and crooked villains. Like any pantomime market participants are portrayed in extremis, stars and dogs, heroes and villains, rather than the frustratingly complex beings most of us are. As much research attests good investment analysts develop a striking “story” of their stocks or sector without allowing mere facts to constrain them too much. Illustrations of such stories are the prediction of a new era of unlimited wealth in the late 1920s or the “digital sublime” of the late 1990s as web technologies liberated business from the need of investment capital allowing “concept” companies to flourish to enormous wealth from a campus dormitory or garage.

Investment decisions manifest tensions beyond the purely social however and expose the everyday battle for self‐command we all know only to well. To revise for our exam or spend the night with friends, to drink orange juice or enjoy a glass of wine. Saving and investing draw on exactly the same tools for self‐control that dieting, not smoking or drinking too much require. In this we all differ, from austere misery guts miser to the obese Champagne Charlie spendthrift. Often these personality differences emerge in childhood. One reason for this is parents often consciously inculcate such attitudes in us by making pocket money conditional on cleaning our room, doing well at school, etc. Other parents avoid simple showering of cash on their offspring. Statman quotes one wealthy executive as stating “Leaving children wealth is like leaving them a case of psychological cancer.” Underserved wealth can abandon us to aimless life. Our objective is rarely to just maximise our wealth but to grow through the efforts such acquisition demands. For those with poor self‐control increases in personal choice, by inherited wealth, greater availability of credit cards, or access to online trading, can be a stumbling block in much the same way as allowing all day drinking only encourages drunkards. One of the most prominent self‐control mechanisms used by investors is not to erode capital.

Textbook writers and finance theorists blithely write about “homemade dividends” delivered by selling stock, but few investors, especially older ones are not having any of this. To sell stock is to “dip into capital” and screams of losing control, or even dignity. A dividend is a wage paid to capital owners and to the retired may even be a lifeline. To sell stock is to sell the farm and cheat the grandkids of their rightful inheritance. Financial institutions know this and so market fixed term investments or stagger withdrawals. The Chicago Board of Trade even markets “covered calls” to those who own stock as a way to raise income. A covered call sells a call option on stock you already own, i.e. is a disguised dip into capital. Such comforting products remain popular with investors who struggle to openly sell their stock to raise income. For standard finance, more choice is always better, but this presumes a degree of self‐control many of us lack. Statman quotes a pop song by Devo to explain this problem. Its lyrics declare “Freedom of choice is what you got. Freedom from choice is what you want”. The tyranny of choice often overwhelms investors trying to construct mental frames to evaluate investment products. Financial institutions understand this and structure their products accordingly. They know we hope for a lifetime of riches but fear dying poor and lonely. It appears as public anger at the big banks has mounted pressure is being placed on credit card companies in particular to recognise customers limited self‐control. The US Credit Card Accountability and Disclosure Act of 2009 sets limits on the overdraft fees, penalty charges and other charges the gullible may agree to but live to regret doing so. This suggests paternalistic motivations for regulatory intervention are alive and well. Good brokerage advice can thus be more about managing the clients conflicting desires and delusional aspirations as opposed to investment allocations as such.

The very balance of hoped for riches and feared poverty explains the structure of many investment portfolios. Government bonds are held as our disaster relief fund with the remainder being invested to reap even greater profits. Investors form “mental accounts” of dividends for income and capital disposals, essential money for educating our children or health care and more speculative funds to have a flutter on the market. Some structured products like British premium bonds try to cover all the bases, ensuring the return of the principal invested plus lottery prizes based on a draw each week from £50 to £1 million. Investors are certainly fearful but few of us truly ever abandon hope. So in post‐communist Albania in 1996 in the depths of economic despair Albanians flooded into a swathe of pyramid structure investment scams which offered huge riches only to implode in violent conflicts in which 2,000 people died. Stocks are investments but also lottery tickets, allowing us to maintain our dreams even in the face of mounting evidence of misery. This may certainly be irrational but it also very comforting and a comfortable life is often a better one. Statman cites Senator Phil Gramm as articulating this vision thus “Some people look at subprime lending as an evil. I look at subprime lending and see the American dream in action.” So investors seek wealth as standard finance claims but they also hold on to dreams. This very tension explains the famous “disposition effect” in investment management which documents we are very hesitant to realise losses yet rush to cash in our gains. Despite the fact only realised losses are tax‐deductible we avoid them because realising losses kills off the hope of selling at a “fair price”, i.e. the one we bought at. Selling at a loss induces pangs of regret, while locking into a gain allows the pleasure of pride. As elsewhere investment decisions engage our emotions not just our mental calculations of prospective cash‐flows. Statman cites broker LeRoy Gross as advising that money managers suggest to clients they “transfer their assets” saving them the regret of selling at a loss. Of course, this is just playing with words. Professional investors seek to avoid such errors by stop‐loss rules such as never sitting on a loss of more than 10 per cent. Frames matter because emotions and not just cognitive calculations are aroused by investment decisions. Framing decision making well is a large part of good investment practice. The decline of online trading without brokerage advice in post‐crash periods suggest the continued need for the comfort of investment advice, if only to have someone to blame for one's poor investment decisions.

The gap between investment practice and standard theory is most acute in the uselessness of the “representative agent” assumption of standard asset pricing models, the CAPM, APT and Black‐Scholes option pricing. Investing like eating or dressing requires different strokes for different folks. Women are more risk adverse than men and less given to frequent trading. The shy are more risk‐averse than the extroverted. We do not need to establish a “right” attitude to risk any more than we need to seek a “right” attitude to eating meat or wearing shorts. We can simply rejoice in the diversity of attitudes to risk and return we observe. But in serving our investment clients their gender, age, wealth and personality are central guiding characteristics. The “right” advise will depend on the person being advised, a customisation standard theory rarely considers. This acceptance of investor diversity within the behavioural tradition encourages the recognition of how cultural traits, such as collectivism versus individualism, desire to avoid uncertainty, or preference for harmony or mastery in group relationships as opposed to generalised, context free, archetypes. So Chinese and American investors may differ in their portfolio decisions, even when given exactly the same choice, because of their different values in making that common choice. Similarly, Asians are often keener to give and receive financial and personal support from their parents, often inviting elderly relatives to live with them in their final years. Of course, the danger is culture is so loosely defined it can explain almost anything. So the same “Confusion culture” that today explains why the Chinese save so much was happily invoked in the 1950s to explain why the Chinese were lazy layabouts who lacked any sense of entrepreneurial spirit. So standard finance theory remains vital to our understanding of financial decisions if we are to avoid descending into a set of blithe cultural and racial stereotypes. These cultural differences extend to attitudes to paying taxes, while Northern Europeans seem willing to pay their taxes, if a little reluctantly, Greeks seem to regard doing so as displaying a naivety verging on the stupid. Indeed, the erosion of the tax base features prominently in the discussion of the financial crisis in Greece. So even if Greeks and Dutch investors display similar attitudes to pre‐tax risk/return tradeoffs their attitude to post‐tax trade‐offs will strongly differ.

One reason why the emotional life of investors is little discussed is that not all our feelings are noble. Snobbish desires for status, recognition and compliments are hard to openly confess. Investors in art, films and theatrical productions are unlikely to be purely seeking high returns and are more likely to have fallen for the allure of private viewings, rubbing shoulders with film stars and other wealthy patrons like themselves. Bernie Madoff always maintained the exclusiveness of his fund further enhancing its allure. The attraction of an “invitation only” club is hard to resist. Hedge funds realise this and limit participation to the seriously rich. This may not be a bad thing as poorer investors may be less able to cope with losses yet the snob appeal of such restrictions is certainly convenient. Statman documents some bizarre status driven behaviour. Fin Caspersen donated $30 million to Harvard Law School, the largest donation in its history. Unfortunately Casperson also had secret offshore bank accounts evading about $100 million in tax. Upon exposure Casperson took his own life. What sort of man simply gives away $30 million while going to such lengths to keep hold of $100 million? Certainly, the IRS are unlikely to name their offices after large taxpayers making payments to them less fulfilling than charitable gifts.

Despite the precepts of standard finance theory few of us evaluate our lives, or those of others, in purely financial terms. Andrew Carnegie stated “a man who dies rich dies disgraced” and the deaths of the famous, Marilyn Monroe, Michael Jackson, Jackson Pollock, etc. remind us of the devastation wealth can bring. We desire wealth, but we also desire meaning, purpose and some sense of achievement mere riches cannot bring. The growth of socially responsible investing and investor boycotts of “sin” stocks like tobacco, alcohol and military, companies suggest this is the case. The generosity of the super rich, Bill Gates, Warren Buffett and Larry Ellison suggest the law of diminishing utility applies strongly to the next billion I earn. But even amongst the less obscenely rich concerns about morality are clear as any discussion of university endowment or pension fund would show. Indeed, since there is no overwhelming evidence socially responsible investing is less profitable than unconstrained investment we may be able to have our cake and eat it, avoiding guilt from funding wars, etc. without any surrender of returns. Such moral concerns can become yet another conveyer of fads and herding in investment flows. Until this decade, environmental concerns were largely dismissed as they view of cranks and doomsayers but now environmental concerns are a primary driver of socially responsible investment. Here again, the emotional and expressive role of our investments complements and sometimes contradicts purely financial objectives. One well‐documented result of this search for meaning is the “home bias” in investors behaviour. Investors are often patriotic and prefer to invest in their “own people” even if foreign investors offer a higher return, suggesting a sense of belonging to a community is valued by them and expressed in portfolio choices. The 9/11 terrorist outrage intensified this feeling in America which saw a revival of patriotic spirit, particularly amongst those with Republican political sympathies.

One value we hopefully all share is a belief in fairness. Nothing is more galling than to see unjust rewards given to others while we ourselves are unjustly denied. The “ultimatum game” demonstrates the power a sense of fairness has. Players are asked to divide a fixed amount, say $1,000 in a particular way. The first player suggests a division which the other player may accept or reject. The other player can accept the offer or abandon the game taking any deal dividing the $1,000 off the table. Obviously it is “rational” for the first player to play hardball offering $1 or even ten cents. If the second player rejects he is always worse off with a rejection only being motivated by pointless spite. It turns out very few first players do anything like that and usually offer something more like an even split. Offers below 20 per cent of the total pot on offer are almost always rejected. Clearly spitefulness is not seen as that pointless by most of us. Of course, the “ultimatum game” is a one‐shot play and depart game. Few financial transactions are of this type. If my bank punishes me too much for being overdrawn I am unlikely to take out a mortgage or life insurance with them. Bargaining occurs in the context of a relationship and a relationship we might both grow to value. But concepts of fairness can vary depending on which end of the spoon you draw from. Statman records that Regulation Fair Disclosure, issued in 2000, requiring price‐sensitive information be simultaneously released to all investors, large and small, simultaneously, brought in more than 6,000 comments to the SEC. Comments from Wall Street professionals were almost universally negative and those from the public or individual investors were universally negative. While a level‐playing field may be fair it was certainly most unwelcome by those who had benefited from a downhill slope for so long. So our morality can be constructed instrumentally to serve our own financial interests as well serving to constrain that interest. To hedge funds high‐frequency trading strategies using computers with execution times no individual trader can hope to match seem fair enough but to their smaller fry victims this may seem less obvious. The market demand for justice is not the sum of parts simply because those parts contradict and negate each other reducing the search for it to self‐serving sloganeering.

I strongly recommend the purchase and study of this book to those, like me, committed to behavioural perspectives on financial decision making. In many ways, its central lessons are depressing. We want it all from our investment portfolios and suffer with the realisation that this is chimera we chase but never capture. Often for the reason for this lies in ourselves and poorly calibrated techniques of self‐control. We confuse a need for investor management with a need to manage our investments. More inspiringly the book reminds of the sheer richness, diversity and occasional perversity of our investment motives. Perhaps the “dull science” is not so dull after all?