Q&A with Professor Meir Statman.

1. Portfolio
Perspectives
November 2013
Advice for Investors — A Q&A with Meir Statman
Statman
We recently sat down with Meir Statman to talk about the role our emotions play in how we make decisions and how
that information can affect investors. Meir, a behavioral finance expert, is the Glenn Klimek Professor of Finance
at Santa Clara University and a member of the Loring Ward Investment Committee. His research has been
published in the Journal of Finance, the Journal of Financial Economics, the Review of Financial Studies, the Journal
of Financial and Quantitative Analysis, the Financial Analysts Journal, the Journal of Portfolio Management,
and many other journals. Meir received his Ph.D. from Columbia University and his B.A. and M.B.A. from the
Hebrew University of Jerusalem.
What is behavioral finance?
Behavioral Finance is the study of the behavior of normal
investors, people like me, people like you. We are normal
smart most of the time but sometimes we are normal stupid.
It is also about how our behavior is reflected in financial markets
and about how to improve the behavior of investors. Once
we understand the cognitive errors that befall us, once we
understand the emotions that are natural to us, we can counter
them where they lead us astray. And this is one of the joys
of being on the committee at Loring Ward because I get to
participate in this great enterprise of trying to help investors
do the right thing.
What is the most significant change you’ve seen
in the area of finance that impacted the way that
investors invest?
What I see is the move from what we know as defined benefits
(pension plans) to defined contributions. It used to be that
people did not have to worry about retirement. They got a job
that had a pension attached to it and they knew that someday
they were going to get a portion of their pay throughout their
lives. That is gone. That has been replaced by 401(k)s and
IRAs. This means that people must know more about finance
than ever.
In your opinion, how can investors use behavioral
finance to have a better investment experience?
Investors who know their cognitive errors and emotions can
create defenses against them when they lead them the wrong
way. For example, why do people trade so much when the
facts show that people who trade the most lose the most? It’s
because people think of trading like playing tennis against
a training wall. But tennis is not played against a wall; it is
played against an opponent on the other side. And in trading, that opponent might be Warren Buffet. Once investors
realize that they have to ask themselves, “Who’s the idiot on
the other side of the trade?” they might conclude that they
are the idiot and stop trading.
If we can get people to pause, to learn about themselves, and
learn to avoid the mistakes, we can do better. Our own retirement, helping our children, contributing to charity…all of these
are more important than wasting our money on trading.
How should “normal” investors invest their money?
Well, before they get to invest their money they have to make
their money. Next we can create systems that will help us
save. For example, if money goes straight from our paycheck
into a 401(k) we don’t have to think about whether we want
to save it or spend it. Once we have saved, then the question

2. Portfolio Perspectives
is, how can we conserve and grow it so much that it is sufficient for us in life and retirement? It is really important for
all investors to have well diversified portfolios that include
stocks, that include bonds, that include real estate, that
include other assets that are going to create a balanced portfolio with relatively low risk relative to the returns. And if we
just maintain it, history has shown we are going to do much
better than if we try to play around with it, manage it, get it
in the hands of active investors, etc.1
How do our emotions affect our investing?
Some people say you have to take emotions out of investing.
But you really cannot do that because emotions are in all of us
and generally emotions do us well. But sometimes emotions
can be exaggerated and mislead us. For example, surely 2008
and early 2009 were scary and that fear is still with us but
what it caused some people to do is to sell all their stocks in
early 2009, and they’re still afraid and so they would not put
the money back in even though the stock market has pretty
much recovered. Now they also have to deal with this emotional regret. If they put their money in today, after they’ve
taken it out at a much lower level in the stock market, they’re
going to feel like idiots. So they’re waiting for the market to
go back to its level in early 2009 before they put the money
in and they get themselves in loops that do them no good.
And so what is important is to realize that we have these
emotions in us. We have exuberance. We have hope. We have
regret. We have fear. All of those emotions can be useful to us
but sometimes they are not. One of the things we try to do in
behavioral finance is to make those distinctions; to find, for
example, that in times when people are still fearful, you’ve got
to expect both lower returns and high risk and use science to
confront that.
How can investors manage their emotions?
The first line of defense is internal. If you know that you are
fearful, step away from yourself and ask whether that fear
has good reason. We know from science that fear is often
exaggerated and you should not act on it. Financial advisors
are a second line of defense because they work as educators.
An investor, a client, would come to them and say, “I’m really
scared of this market. This idea of ‘for the long run’ really does
not work for me because I’m just too scared. I want to get all
of my money out of stocks.” To the extent that advisors can
explain what science shows, how emotions work, and then
persuade investors not to act rashly, then advisors have done a
great service to their clients.
Research shows that over confidence is a major
investor error. Can you explain it?
Over confidence is a major cognitive error with an
emotional component to it. Some investors know that trading is
like playing tennis against an opponent. But somehow they’re
over confident in their ability and so they say, “It is one of the
Williams sisters on the other side of the net, but you know
I’ve never played her. It might be that she will win and it
might be that I will win. I’m going to wager $10,000 on it.”
Of course that is stupid but that really is what over confidence does to us. You can trade and by luck you may make
money, and you’ll think that that is evidence that you are a
genius. Next time you’re going to put even more money into
it and you’re going to lose. Over confidence is useful for us in
many settings but not in investments.
How do you invest?
Last year I was speaking at a conference and was asked, how
do you invest? And I said, I invest exclusively in index funds
and passive asset class funds. Afterwards, one of the people
came to me and he said, “Here you are, somebody who knows
a lot about finance, and you invest in index funds and passive
class funds. Why?” And I said I invest in index funds because
I know a lot about finance, because I know the science of
finance and because science tells me that I will probably get
better results in terms of risk and return by investing in a well
diversified portfolio composed of index funds. The less you
play with it, the better off you are. The less you manage it, the
better off you are. Keep your investments simple so you can
spend your time doing actual work and enjoying your family.
Fisher, Kenneth L. and Meir Statman (2000),“Investor Sentiment and Stock Returns”, Financial Analysts Journal, 56 (2), pp. 16-23.
Diversification neither assures a profit nor guarantees against loss in a declining market.
Bonds are subject to market and interest rate risk. Bond values will decline as interest rates rise, issuer’s creditworthiness declines, and are subject to availability and
changes in price.
Stock investing involves risks, including increased volatility (up and down movement in the value of your assets) and loss of principal.
Real estate securities funds are subject to changes in economic conditions, credit risk and interest rate fluctuations.
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Securities transactions are offered through its affiliate, Loring Ward Securities Inc., member FINRA/SIPC. R 13-380 (Exp 10/15)
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