Managing the-mental-aspect-of-investing


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Managing the-mental-aspect-of-investing

  1. 1. Portfolio StrategiesManaging the MentalAspect of InvestingAn Interview with Meir Statman Article Highlights • Two common investor errors are not considering who is on the other side of a trade and holding incorrect assumptions about the past. • Investors do not need to avoid herds, but rather need to distinguish between good herds and bad ones. • By not taking credit for gains, investors can better cope with the emotions of recognizing a loss. Meir Statman is the Glenn Klimek Pro- tion relative to that of a likely traderfessor of Finance at Santa Clara University, on the other side of the trade. Is mySanta Clara, California, and author of the analysis of companies in my sparerecently published “What Investors Really time better than those of professionalWant” (McGraw-Hill, 2011). I spoke to analysts who do their work full time?him recently about mental hurdles investors Do I have private information aboutface when making investing decisions. demand for and supply of stocks Charles Rotblut, CFA available to institutional investors? Is it possible that I’ll be trading against Charles Rotblut (CR): In your insiders who are trading legally or il-book, you talk about how people commit legally? I conclude that I have no likelycognitive errors such as confirmation errors advantage over other traders, so I doand hindsight errors. Can you elaborate not trade.on the kinds of cognitive errors that people commit when they make Hindsight is another example of a cognitive error. In-financial decisions? vestors say, “I knew in 2007 that the market was going to Meir Statman (MS): I begin with framing errors. We tumble in 2008.” Maybe so, but I would like to see their 2007tend to frame trading stocks, mutual funds, and other invest- diary, written in permanent ink. My guess is that in 2007ments as tennis played against a practice wall, where we see they wrote something like this: “I’ve read that the housingthe ball hit the wall and place ourselves at the right spot to market is in a bubble, and this seems to be true as I observehit it back. But the correct frame of trading is real tennis prices in my neighborhood. But are we really in a bubble?against a player on the other side of the net. Would you play And when would the bubble pop?” But when we get intotennis when Roger Federer might be on the other side of the 2008 and 2009 they remember that they have known withnet if the loser pays $100,000 to the winner? So why are you clear foresight not only that the housing market would col-trading when Goldman Sachs might be on the other side of lapse but also that the banking system and the stock marketthe net? Remember, there is an idiot in every trade, and if would collapse. And did the people who were smart enoughyou do not know who it is, it is likely you. to sell their stocks at their tops in 2007 also buy them back Some investors who frame the trading game correctly as at their bottoms in 2009?tennis against a player on the other side of the net are often Some months ago I was speaking to a group of verytripped by overconfidence. They know that the better tennis wealthy investors. One said, “I have a friend who just knewplayer would win, but surely they are the better player. They in 2007 that the stock market was going to tank, and still heknow that there is an idiot in every trade, but surely it is the found it hard to pull the trigger. Why is that?” I tried to say,other trader who is the idiot. as gently as I could, “I don’t think that your friend was as Whenever I am tempted to trade, I think about my posi- certain in 2007 as he is now. In 2007 he hemmed and hawed,May 2011 17
  2. 2. with ‘ifs’ and ‘buts’ and ‘on-the-other- does Joe know about money manage- want to leave nothing for the tax man.hands.’ It is only in hindsight that all ment? Did he examine the operations of The sum of our wants and behaviors‘ifs’ and ‘buts’ and ‘on-the-other-hands’ Bernie Madoff ? And if he did, does he makes financial markets go up or downdisappear. Now he only remembers that know what they mean?” The answer was as we herd together or go our separatehe forgot to pull the trigger and vows not no. Joe decided to invest with Madoff ways, sometimes inflating bubbles andto forget to pull the trigger next time.” on the recommendation of David, who at other times popping them.These are only a few of the cognitive made his money as a surgeon. The blinderrors that stand between us and good who follow the blind form a bad herd, CR: So you think there are emotionalfinancial decisions. likely to plunge off a cliff. gains, in addition to financial gains, that investors seek out? CR: What about herd behavior? In your CR: For individual investors trying to MS: Investments are like, you mention it as being both positive decide which herd to follow, how do they make The benefits of jobs come in packagesand negative. a decision? and we face trade-offs as we choose MS: Investors often use the lan- MS: Avoiding herds is very easy. among them. A lawyer who wants toguage of herding to describe other Rely on what you know from scientific earn money but is also passionate aboutinvestors. “These are idiots, members of studies. We know that the “value” herd is public advocacy can choose a publicherds.” Investors rarely see themselves as more likely to be right than the “growth” advocacy package with little money andmembers of herds. “I’m an independent herd. So tilt your portfolio toward the much passion or a corporate law packagethinker,” they say. But whenever you value herd, but not too much. Keep a with more money but less passion. Thewatch CNBC or Bloomberg, you see well-diversified portfolio, because some- benefits of investments, like those oftwo professionals, both wearing suits times the value herd lags the growth jobs, extend beyond money. Investmentsso you know they are experts, yet one herd. Avoid framing errors, overconfi- express parts of our identity, whethersays that the market is sure to go up dence errors and hindsight errors. Be that of a trader, a gold accumulator, orand the other says that it is sure to go aware that the future is uncertain and a fan of hedge funds.down. They cannot both be right. At that black swans are not black swans if Investments are a game to many ofany moment we have a herd of bulls we foresee them. Knowing that a major us, like tennis. We may not admit it, andand a herd of bears. And each herd is earthquake, tsunami, and nuclear disaster we may not even know it, but our actionssplintered into sub-herds: Some bears can happen is not the same as knowing show that we are willing to pay moneysay that the market is bound to collapse where and when they would happen. for the investment game. We pay thebecause the Federal Reserve prints too money in trading commissions, mutualmuch money; other bears say that it is CR: With regard to your book’s title, if fund fees, and software that promises tobecause government imposes excessive I were to ask our members what they really tell us where the stock market is headed.regulations. want, their answer would be capital gains and And investments are about what we We need not avoid herds. We need portfolio income. However, you think there are would do with the money we make andonly to distinguish good herds from bad other things that investors want as well, correct? how it makes us feel. Investments areones and join good herds. MS: We want high returns from our about a sense of security in retirement, For example, Consumer Reports investments, but we want much more. our hope for riches, the joy and pride oftests cars and surveys car owners and We want to nurture hope for riches and raising our children, and paying for theconcludes that Honda is a reliable car banish fear of poverty. We want to be college educations of our grandchildren.and Mercedes Benz is prone to break- number one and beat the market. We Investments, jobs, products and ser-downs. I join the Honda herd when I want to feel pride when our invest- vices have benefits that enhance wealth,buy a Honda, and this is a good herd. I ments bring gains and avoid the regret well-being, or both. These include utili-avoid the bad herd of Mercedes Benz. I that comes with losses. We want the tarian benefits, expressive benefits, andknow that I can trust Consumer Reports status and esteem of hedge funds and emotional benefits. Utilitarian benefitsbecause they are experts at evaluating the warm glow and virtue of socially are the answer to the question, “Whatcars. I also know that their surveys are responsible funds. We want good advice does it do for me and my pocketbook?”free of bias and that they do not have from financial advisors, magazines and The utilitarian benefits of watches in-conflicts of interest because they do not the Internet. We want to be free from clude telling time, the utilitarian benefitsaccept advertising from car companies government regulations yet be protected of restaurants include nutritious calories,or others. by regulators. We want financial markets and the utilitarian benefits of invest- Compare that with my situation to be fair but search for an edge that ments are mostly wealth, enhanced bywhen Joe, my country club buddy, told would let us win: We want markets that high investment Bernie Madoff was a good money are sometimes fair and at other times Expressive benefits convey to us andmanager. I said to myself, “Joe made his not. We want to leave a legacy for our to others our values, tastes, and in the junkyard business, what children when we are gone. And we They answer the question, “What does18 AAII Journal
  3. 3. Portfolio Strategiesit say about me to others and to me?” courtesy of the IRS.) least my laptop is intact.” The same isA stock-picker says, “I am smart, able to true in investments. Yes, I lost muchpick winning stocks.” A Goldman Sachs CR: And would you say the reason why more than $250 in 2008 and early 2009,client says, “My status is high enough to investors sit on losses is that they just have a but it could have been selected to invest $2 million or more hard time “shrugging their shoulders”?in Facebook shares.” MS: I think so. I think that inves- CR: To take that a step farther, for those Emotional benefits are the answer tors should make the best decisions they who lost a lot of money during the last bearto the question, “How does it make me can and shrug their shoulders, whether market and still haven’t made it up, does thefeel?” Insurance policies make us feel these good decisions turn out well or same kind of thinking apply? Should theysafe, lottery tickets give us hope, and badly. I do not pretend that this is easy. I remind themselves that there are other peoplean offer to be among the first to own recently returned from the Netherlands, in the same situation?Facebook shares makes us proud. where I serve as a visiting professor at MS: Ask yourself, did the losses Tilburg University. I spent the weekend of 2008 and 2009 injure your retire- CR: Let’s talk about losses. As you know, before my return in Amsterdam. I put ment prospects or only your ego? Theinvestors are often reluctant to realize a loss, my $250 or so of American money in a retirement prospects of people witheven when doing so is the smartest move. Any pocket of my suitcase, so that my wallet $10 million who have lost $4 millionsuggestions for how to do cope with the emotional containing euros would not be too bulky. are still pretty good even if their egosaspect of losing money on an investment? I was checking that pocket on my way are battered. Does the loss of $400,000 MS: The utilitarian benefits of real- to Schiphol airport, ready to replace the of your $1 million portfolio mean thatizing losses are in tax savings. I can write euros in my wallet with dollars, but the you cannot be retire at 55? What’s wrongoff realized losses against my income dollars were not there. “Boy,” I said, “it about retiring at 60 or 65 if you’re luckyor realized gains, but I cannot write off must have been the cleaning woman.” I enough to hold a job or operate a busi-paper losses. So it makes sense to real- was trying to shrug my shoulders, but it ness? And you’re still better off thanize losses. But realizing losses detracts was hard to do. I sent an e-mail to the people who’ve lost their jobs along withfrom the expressive benefits of invest- hotel saying, “This is not right. You’d big chunks of their portfolios.ments by exposing me as a loser. And better investigate and return my money.” Also, remind yourself not to takeit detracts from emotional benefits by I was trying to put it in perspective, credit for gains, because this would bringinflicting the emotional pain of regret: saying to myself, “Okay, Meir, in the blame for losses. When the market goesYou think, why was I so stupid as to total scheme of things, a stolen $250 is up, I remind myself that it’s because Ibuy this stock? If I realize my loss, I will not a major disaster.” Still, I was berat- was lucky, not because I’m smart. Andkiss my money goodbye and abandon ing myself about being so stupid as to when it goes down, it is because I wasall hope of recovering my losses. put the money in a front pocket. But I unlucky, not because I’m stupid. I have trained myself to realize my reminded myself that I’d been doing thatlosses, suffer the pain of regret, and on countless trips where all went well. CR: Finally, you do talk a little bit inenjoy the tax benefits. For example, I had When I arrived at my New York your book about “baskets.” Many of ourlosses in my international fund during hotel, I opened the pocket of my laptop members are retirees, and they are dependentthe crisis, so what did I do? I realized case, where I carry the charger and other on their portfolios for dividends. How shouldthese losses by selling the fund and accessories, and there were my dollars, they view dividends relative to the rest ofbuying another international fund that folded just as I had placed them. I was their portfolios and figure out what “basket”was not identical to the one I sold (so I really embarrassed, and sent the hotel everything fits in to?won’t have to worry about the problem an e-mail saying, “It was my mistake, MS: We distinguish capital fromof wash sales). I said to myself, “Hey, please forgive me!” income and tend to follow the ruleMeir! Stuff like that happens! Get over it, of “spend income, but don’t dip intoshrug your shoulders and make the best CR: In terms of controlling emotions, do capital.” We give ourselves permissionof it.” I never take credit for gains, so I you think it’s just a matter of trying to keep to spend dividends and interest incomecan absolve myself of blame for losses. things in perspective? but not to sell stocks to finance con- Now I have a lot of realized losses MS: Keeping things in perspective sumption. The problem comes whenthat I carry forward, yet my new for- can help a great deal. We feel really the dividend yield is lower than 2% andeign stock fund has accumulated very bad if we’ve just lost $250. But ask interest is close to 0%. A $1 million port-nice unrealized gains. Earlier this year yourself, “What is $250 relative to my folio yields income lower than $20,000.I deposited money in my charitable total wealth?” Remind yourself that You’ll need a pretty substantial $3 millionaccount. I took that money from the $250 is nothing relative to real calami- portfolio to generate a $60,000 fund that has unrealized ties such as earthquakes and tsunamis. Retirees should remind themselvesgains. This way, a dollar donation cost Ask yourself, “What could I have done? that, sad as it is, we are all destinedme less than a dollar. (The rest is paid I cannot carry everything with me. At to die. Running out of money whileMay 2011 19
  4. 4. alive is bad, but so is living like misers Managed payout funds offered by a controlled one. They spend $70,000only to leave much money when we’re Fidelity, Vanguard and others are sen- of their $1 million portfolio and knowdead. People in their 70s and 80s can sible methods of dipping into capital. that they have to wait another year fordip into capital, but such dips must be Investors can choose a 7% payout dip another payout. Others can choose acontrolled. into capital. This is a substantial dip, but more conservative 5% or 4% payout.  Meir Statman is the Glenn Klimek Professor of Finance at Santa Clara University, Santa Clara, California. His book, “WhatInvestors Really Want” (McGraw-Hill, 2011), was recently published. Find out more about Statman at Charles Rotblut, CFA, is vice president at AAII and editor of the AAII Journal. Follow him on Twitter at Financial Planning(Continued from page 16)his or her own benefit or the worker’s not in good health, taking the Table 6. Breakeven Ages and Accumulationdelayed benefit. benefit is indicated. If he or The individual who has delayed she is in good health, delay- Aftertax Breakeven Yearstaking Social Security benefits until his ing the benefit is indicated for Return Age to Accumulationor her full retirement age faces a slight the maximum-wage earner. (%) (Years, Months) Breakeven ($)dilemma. Workers who have attained full Since benefits are automatic 4.00 81, 2 15.2 580,490retirement age can collect benefits and at age 70, greater retirement 5.00 82, 3 16.3 700,490continue working without a payback of income will be available with 6.00 83, 7 17.6 873,976any Social Security benefits. (Actually, reasonably good probabilities 7.00 85, 3 19.3 1,141,171those wages need not even be reported of surviving beyond the break- 8.00 87, 6 21.5 1,604,439to the Social Security Administration.) even age. 9.00 90, 10 24.8 2,578,889There is no question if the individual It seems reasonable that 10.00 96, 8 30.7 5,582,487simply retires. But if the individual is the average-wage earner would 11.23 Never Never N/Agoing to continue to work, the economic use the Social Security benefitconsideration is “breakeven.” to add to their lifestyle, and so Breakeven for average- and maxi- taking the benefit is indicated at age 66. life expectancy of a female; therefore,mum-wage earners is in the latter half The maximum wage earner may never taking the benefit at age 66 is indicated.of the 13th year (between ages 78 and need the benefit and would simply invest Should the combined worker and spou-79). Life expectancy at age 66 is ap- the aftertax amount. At aftertax rates sal benefit be invested, the breakevenproximately 16 more years for a male of return between 4% and 10%, the age is well beyond both life expectanciesand 19 more years for a female. Thus, breakeven age is at least the life expec- and, again, taking the benefit at age 66for all wage earners, if an individual is tancy of a male and just short of the is indicated.  Robert Muksian, Ph.D., is a professor of mathematics at Bryant University, Smithfield, Rhode Island. Find out more at AAII Journal