Meir Statman on the Behavioral Obstacles Affecting Investing and Retirement Planning

Meir Statman is the Glenn Klimek Professor of Finance at the Leavey School of Business, Santa Clara University, and Visiting Professor at Tilburg University in the Netherlands.

His research on behavioral finance has been supported by the National Science Foundation, CFA Institute, and Investment Management Consultants Association (IMCA) and has been published in the Journal of Finance, Financial Analysts Journal, Journal of Portfolio Management, and many other publications.

A recipient of two IMCA Journal Awards, the Moskowitz Prize for Best Paper on Socially Responsible Investing, and three Graham and Dodd Awards, Statman consults with many investment companies and presents his work to academics and professionals in the U.S. and abroad.




Annuity Digest: Your book What Investors Really Want provides a comprehensive and practical look at behavioral finance in the lives of investors.  Are investors aware of behavioral finance?   

Meir Statman: People in the investment field are generally aware of behavioral finance, but I worry that they misperceive it. I worry that we have moved from the cardboard image of investors as rational to the cardboard image of investors as irrational and lost the true image of normal investors in the process. Normal investors are investors like you and me, often normal-smart but sometimes normal-stupid. I also worry that we have lost the connection between investments and the life of investors beyond investments. I wanted to understand what normal investors really want. And I wanted to describe normal investors as they really are. Because investors who fail to understand themselves cannot help themselves, and advisors who fail to understand normal investors cannot help them.

Standard finance describes investors as computer-like rational people, doing everything right. Much of behavioral finance describes investors as bumbling irrational people doing everything wrong. It is time to describe investors as normal, often right and often wrong.

I also worry that investors see behavioral finance as a tool for beating the market by taking advantage of the errors of others, rather than protect themselves from themselves.

Normal investors want more from investments than profits equal to risks. We want to nurture hope for riches and banish fear of poverty. We want to win, be #1, and beat the market. We want to feel pride when our investments bring gains and avoid regret when they inflict losses. We want the status conveyed by hedge funds and the virtue conveyed by socially responsible funds. We want financial markets to be fair but we search for an edge that would let us win. We want to leave a legacy for our children when we are gone. And we want to leave nothing for the tax man.

Annuity Digest: In your book you talk about the 3 different benefits of investing. What are they and what are the tradeoffs among them?

Meir Statman: The benefits are utilitarian, expressive, and emotional. Utilitarian benefits are the answer to the question: What does it do for me and my pocketbook? The utilitarian benefits of watches include time telling, the utilitarian benefits of restaurants include nutritious calories, and the utilitarian benefits of investments are mostly wealth, enhanced by high investment returns.

Expressive benefits convey to us and to others our values, tastes, and status. They answer the question: What does it say about me to others and to me? Private banking expresses status and esteem. A stock picker says, “I am smart, able to pick winning stocks.” An options trader says, “I’m sophisticated, willing to take risk and knowing how to control it.”

Emotional benefits are the answer to the question: How does it make me feel? The best tables at prestigious restaurants make us feel proud, insurance policies make us feel safe, lottery tickets and speculative stocks give us hope, and stock trading is exciting.

We face tradeoffs everywhere. A man can take his date to a local Italian restaurant where he would pay $30 for 1,000 utilitarian calories for each of them. Or he can take her to a fancy French restaurant where he would pay $300 for the same 1,000 utilitarian calories plus expressive and emotional benefits. The man gains expressive benefits as he expresses to his date his riches and generosity. He gains the emotional benefits of pride in himself and the hope that this night's date would lead to more. Sometimes the choice of the expensive restaurant is best. But we must know the tradeoffs between the three kinds of benefits. We can't have it all.

Annuity Digest: Wouldn't retirement income sustainability fall almost entirely into the utilitarian camp?

Meir Statman: No, I don’t think so.

People who know they have a pension or annuity income coming every month have more than utilitarian well-being, they also have psychological well-being. People with pensions, annuities or other guaranteed income are happier in retirement and show fewer symptoms of depression than people with equal income from sources which are not as assured.

Annuity Digest: Why not seek expressive and emotional satisfaction in alternative settings with less downside--such as the golf course, Vegas or gardening?

Meir Statman: People obviously do this—most of us find different channels from which to derive expressive and emotional benefits.

Think, for example, about social status which is an expressive and emotional benefit.  People choose their arenas for status competitions. Hedge fund managers compete with hedge fund managers and academics compete with academics. People with little status in their day jobs might find status on the golf course during the weekend. Yet other people insist of competing for status in the investments arena.

Annuity Digest: Does it make sense to question the sensibility of active investing among individual investors when the data do not support it? Why do investors continue to swim upstream?

Meir Statman: This is exactly the type of question that prompted me to write the book.  I have been presenting this fundamental question to my students for years.

There is hardly a utilitarian case to be made for individual investors buying active mutual funds and playing other beat-the-market games. The same is true for many institutional investors. So why do investors persist in playing the beat-the-market game? One part of the answer is in cognitive errors and misleading emotions.  Think about framing.  Investors often frame the beat-the-market game as playing tennis against the practice wall. But the game is real tennis, with possibly world-class opponents on the other side of the net. Would you play tennis against Venus Williams if $100,000 would be paid by the loser to the winner?

The other part of the answer is in the expressive and emotional benefits of the beat-the-market game. Index investing is "mediocre." We hate to be mediocre. We want to win, even if we are likely to fall below mediocre when we play the game. Playing the game gives us hope, like buying a lottery ticket, even if the game is stacked against us. And we enjoy playing the beat-the-market game as we enjoy playing video games or skiing. We have no trouble admitting that we ski for expressive and emotional benefits even if it costs us utilitarian money. But we have great trouble admitting, even to ourselves, that we play the beat-the-market game for expressive and emotional benefits.

Annuity Digest: Would you agree that investing is in an entirely different class of issues since playing-around with retirement assets raises the stakes to a much higher level?  In other words, a tough weekend in Vegas is one thing, but potentially depleting one’s retirement funds is quite another.

Meir Statman: There is indeed a big difference between losing $1,000 in Vegas and losing our retirement savings in foolish investments. This is why I think that many of us would benefit from a dose of paternalism, despite the howls of libertarians.

Think about Social Security—what if Social Security is privatized and some people gamble away their money.  Are we really ready to say tough luck, now you'll live in the gutter? I'm not ready to say that.

Annuity Digest: What is your view on the viability of the defined contribution system for retirement funding?

Meir Statman: I think defined contribution plans such as the 401k are an essential part of our retirement system.

The defined benefit system is not sustainable.

What we do need is to strengthen the defined contribution system.  For example, some countries have a three-leg system consisting of a state-sponsored program similar to Social Security, mandatory savings, and voluntary savings.

In the United States, the second and third legs are lumped together in a 401k and IRA since the contributions to these plans are voluntary.

What this means is that many people are condemned to live entirely on Social Security, and this is not viable.

Participation in 401k should be mandatory and minimum contribution levels should be set.

Annuity Digest: Would we be better-off from a societal welfare perspective under a defined benefit system?

Meir Statman: No.

Just think about defined benefits in the context of public employees and the type of corruption it invites.  Politicians make promises of future pensions that are beyond what taxpayers can pay and then simply pass the problem along to other politicians.

The state of California is a perfect example—the game is corrupt since it is based on unsustainable promises. What we need is a transparent system. A policeman might have a salary of $80,000 per year plus opaque benefits worth another $80,000. Let's make sure that we all see the $160,000 total and that it comes out of today's budget. This will invite the proper backlash from taxpayers, forcing politicians to confront unions and reduce total compensation to reasonable levels.

Again, I would advocate a mandatory defined contribution system for all employees in both the public and private sectors.

Annuity Digest: Do you have any thoughts or comments on Teresa Ghilarducci's 401k-related views?

Meir Statman: Some aspects make sense and some do not.

Mandatory savings makes sense and there is a case to be made for taking away investment discretion now available to individuals.

Government guarantees beyond Social Security do not make sense. We should, as a nation, provide a minimum standard of living for old people, but no more than that. (Think of the Medicare money we, taxpayers, must pay to keep Joe's 98-year old Grandma on life support because Joe refuses to let us pull the plug yet cannot be compelled to pay for his Grandma's care.)

Annuity Digest: Can you comment on the value of private annuities?  Can private annuities help address some of the retirement system problems since they are analogous to a personal pension plan?

Meir Statman: Sure, but we can structure annuities and quasi-annuities in a number of different ways—immediate annuities, managed withdrawal programs or a combination thereof. People seem to prefer managed withdrawal programs over immediate annuities.

Managed withdrawal programs do not eliminate longevity risk.  I challenge you, though, to find a middle class person who has run out of money in retirement.  People are not stupid—they adjust their spending when there is a downturn in the stock market or when they see that they are spending too much. Moreover, people often have a buffer in the form of home equity they do not count as part of their portfolio but is available if needed.

Annuity Digest: In your book you address the problem of under-spending in retirement by people who are so accustomed to saving.  Can annuities help?

Meir Statman: Yes. The forced withdrawals from 401k and IRA accounts after age 70.5 serve to force or at least induce people into spending from their portfolios. There might be reason to argue that 70.5 should be lowered to 65.

Annuity Digest: In your book there is frequent reference to the financial advisors as physician physicians.  But does the analogy hold?

Meir Statman: Some people say that the analogy does not hold because physicians know much more than advisors. But I think that our estimates of physicians' knowledge are biased upward and our estimates of advisors' knowledge are biased downward. Both professions have fiduciary responsibilities and it is not clear to me that physicians fulfill their responsibilities any better than advisors.

The similarities are many. Good physicians promote health and well-being and good advisors promote wealth and well-being.

Annuity Digest: Thank you very much Meir.

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