Monday, November 27, 2017

Finance for Normal People

Standard financial theory treats us as though we are all perfectly rational people who make no mistakes in maximizing our utilitarian benefits with each of our financial choices. In reality, we’re emotional creatures who have desires outside of utilitarian needs. We have limited time and ability to evaluate choices, and we make lots of mistakes.

Many books have been written about how people fail to make the best rational choices. What sets Meir Statman’s Finance for Normal People apart is his attempt to unify real human nature into a realistic theory of finance.

“We want three kinds of benefits—utilitarian, expressive, and emotional—from all products and services, including financial products and services.” We’re used to focusing on utilitarian benefits such as maximizing portfolio returns. However, we also seek “the expressive benefit of high social status, as by a hedge fund; and the emotional benefits of exhilaration, as by a successful initial public offering.”

Sometimes we make cognitive and emotional errors, but this is distinct from seeking expressive or emotional benefits. Feeling good has value. It is perfectly sensible to add up utilitarian, expressive, and emotional benefits when making a choice. It’s a cognitive error when we misjudge benefits.

For example, it’s sensible for a wealthy person to say “I have more money than I need, and I don’t mind sacrificing some returns when I pick my own stocks.” For almost all people, it becomes a cognitive error when we believe that our own stock picks will beat the market. “Investors who believe they can pick winning stocks are regularly oblivious to their losing records, recording wins as evidence confirming their stock-picking skills but neglecting to record losses as disconfirming evidence.”

Because we have limited time and attention, we use cognitive and emotional shortcuts to make decisions. This works well most of the time. “Cognitive and emotional shortcuts turn into errors when they take us far from our best choices.” Keep in mind that “best choice” is defined in terms of all types of benefits: utilitarian, expressive, and emotional.

One type of cognitive error we make is called a “framing error.” Stock traders who “frame the trading race as between them and the market” are making an error. “Traders possessing human-behavior and financial-facts knowledge frame trading correctly as against traders on the other side of the trades—the likely buyers of what they sell and likely sellers of what they buy.”

In everyday language, we use “rational” to mean roughly the same as “smart.” “Financial economists, however, use the term more narrowly” to refer to people who “want only utilitarian benefits from investments.” While there is no utilitarian benefit from buying your date a rose, it is perfectly rational in the everyday sense of the word.

Statman criticises those who advise us “to set emotions aside when we are making financial choices, and use reason alone.” He says that “we cannot set emotions aside,” and that “emotional shortcuts complement reason.” I think this apparent disagreement is mostly semantic. I suspect both sides would agree that it makes sense to think carefully about big financial decisions and avoid making a snap emotional choice. Those with less technical knowledge in behavioural finance than Statman has might compress this advice to “keep emotions out of it.”

Even optimism can lead to emotional errors. “Optimism enhances our daily life as we contemplate an enjoyable future, but optimism has downsides.” A study of Finns found that “Optimism can lead to excessive debt loads.”

On the question of whether financial advisers help investors avoid cognitive and emotional errors, Statman says “Evidence indicates that financial advisers improved the financial behavior and well-being of both working and retired people.” I scanned the four papers he references that offer evidence of financial adviser benefits. I suspect that the benefits are greatest for those with enough money to get advice from a fiduciary. Those getting “suitable” advice likely benefit less, if at all.

In an example of understatement, Statman says that many firms, including “banks, hotels, health clubs, mutual fund companies, and credit card companies” “choose to exploit their customers’ errors, such as by hiding information or shrouding it.” A good example of this is the 7-page confusing investment account statements I get that bury mandatory disclosures about fees near the end.

All is not lost. “We are susceptible to cognitive and emotional errors, yet can correct them by human-behavior and financial-facts knowledge.” So admitting we make mistakes and understanding them can help us make better choices in the future.

“Expected-utility theory and prospect theory are two theories that assess happiness and predict choices. Expected-utility theory was introduced by mathematician Daniel Bernoulli.” My assessment of Bernoulli’s paper is that he was not trying to predict choices. He was saying how people should make choices, not how they actually do make choices. It may be that later economists incorrectly claimed that people actually make choices based on expected-utility theory, but I’ve seen no evidence that we should pin this on Bernoulli.

We’d like to think we’re not susceptible to trying to keep up the Joneses, but a study showed that lottery winners “increased visible assets, such as houses, cars, and motorcycles,” and this caused a “rise in subsequent bankruptcies among the close neighbors of these winners.”

I won’t repeat discussions of parts of this book I’ve discussed before about the dividend puzzle, portfolio optimization, and the annuity puzzle.

In a discussion of sustainable spending in retirement, Statman claims that “Older people in developed countries reduce their spending substantially starting at about age seventy and accelerating afterwards.” The reason, he says, is “physical limitations make them less able to spend, such as on travel, and because they are less inclined to spend for personal reasons.” He points to Fred Vettese’s work to justify leaving out what I think is the dominant reason retired people begin spending less: they overspent in their first few years of retirement. I wrote a critique of Vettese’s arguments in a previous article.

When investing, we seek more than just utilitarian benefits; we also seek expressive and emotional benefits such as “holding socially responsible mutual funds, the prestige of hedge funds, and the thrill of trading.” Unfortunately, investments with high expressive and emotional benefits “tend to be associated with high prices and low expected returns.”

Cognitive and emotional errors hurt our returns as well. Some examples are the “belief that stocks of admired companies are likely to yield higher returns than stocks of spurned companies, and that frequent trading is likely to yield higher returns than rarer trading.”

Statman goes through 5 possible explanations for the higher “factor” returns of value stocks and small-cap stocks. The first three explanations come from standard financial theory, and the final two come from behavioural financial theory. He concludes that behavioural financial theory explanations are more likely: “the evidence favors the emotional-errors and wants hypotheses over the data-mining, risk, and cognitive-errors hypotheses.”

To the growing list of investing “factors” such as value stocks and small-cap stocks, Statman adds some possible behavioural factors. One example is that stocks that rank low on social responsibility likely having higher returns.

In a discussion of three forms of the efficient market hypothesis (EMH), it struck me that the definitions seem to be based mostly on access to information and whether it is possible to profit from it with short-term trading. However, the best example of an investor who defies the EMH, Warren Buffett, made his billions with long-term investment. His advantage seemed to have less to do with having exclusive information and more to do with being better able to analyze how a company’s culture and strategy will play out over the long term.

Overall, I found this book to be very helpful at taking what I’ve learned elsewhere about human behaviours and mistakes and putting them in a useful context and framework. Our expressive and emotional needs aren’t mistakes; the mistakes come when we over- or under-value them. Statman says “I hope you see yourself in this book and learn to identify your wants, correct your errors, and improve your financial behavior.”


  1. That sounds like a really good book, a copy just became available for me at the library :)

    1. @Greg: I've found my house doesn't clutter up as fast since I started using the library instead of buying books.