Charles Schwab’s YieldPlus funds promised returns higher than those of bonds at only slightly higher risk. Schwab classified the funds as ultrashort bond funds yet their holding were concentrated in mortgage backed securities which were decimated in the financial crisis.
The story of YieldPlus is only one example of the sad consequences of investors’ perennial search for returns higher than risk. A century ago investors sought such returns in stocks of mining companies. A magazine of the time told the story of a man, the son of a country doctor, who reached adulthood and was about to go into business. His father took him into the little back office, swung open the door of the rusty old safe, and took out a thick bundle of stock certificates. “My son,” he said, “you are going into business, and, I hope, will make some money. . . . When the time comes you will wish to buy some mining stock. Everyone does. When that time arrives come to see me. I will sell you some of mine. They are just as good, and will keep the money in the family.’”
Lessons from a century ago need repeating because we fail to learn. Almost half a million Italian retirees bought Argentine bonds in the 1990s because they offered higher interest rates than Italian bonds. The word default became an Italian word in 2001 when Argentina defaulted on its bonds. In 2005 Nestor Kirchner, Argentina’s president at the time, offered to pay bondholders less than a third of their investment. When Rodrigo de Rato of the International Monetary Fund called on Argentina to be respectful to bondholders, Kirchner mocked him, “It’s pathetic to listen to them sometimes.” “Enter now,” said Kirchner to the bondholders, “or it will be your problem.”
Banks sold $7 billion of reverse convertibles in 2008, promising returns higher than risks and collecting fees in the process. Reverse convertibles are bonds linked to stocks such as Apple and Johnson & Johnson. Investors were promised high interest rates during the life of the bonds in addition to their invested money when the bonds mature. Yet if the prices of the stocks to which the bonds are linked fall, investors get the stocks rather than their invested money. The high interest rates of reverse convertibles were enticing, but not all investors were aware of their risks. Lawrence Batlan, an 85-year-old retired radiologist, invested $400,000 in reverse convertibles linked to stocks such as Yahoo! and SanDisk. He lost $75,000 of it when stock prices declined. “I had no idea this could happen,” said Dr. Batlan. “I have no desire to own Yahoo! stock or the others.”
The “accumulator” was also an investment that was too good to be true, but this one was offered mainly to investors in Hong Kong. Accumulators obliged investors to buy shares of a stock at a fixed price. Investors profited if the price of the shares increased but lost if the price decreased. Yet the profit potential of investors was limited by a condition mandating that they sell their shares back to the issuer if their price increases to a specified level. The year 2008 was bad for investors in accumulators as stock prices declined and investors nicknamed accumulators “I kill you later.” The fundamental flaw . . . is something that I learned from my grandmother,” said Kathryn Matthews, an investment professional. “You get nothing for free.”
Next time when you see an investment with “plus” in its name, substitute “minus” in its place and see if it is still as enticing.
Think of investments as ingredients of a stew, some with fat returns and some with lean. Now think of the investment market as a giant well-mixed vat of stew that contains all investments. Some investors dip their ladles into the stew and fill them with fat and lean in proportions equal to the proportions in the market vat. These are index investors who buy index funds that contain all investments. Index investors pay the expenses of their funds, but they can easily find index funds whose expenses are very low, equivalent to a few teaspoons of stew taken out of their ladles. Index investors tend to be buy-and-hold investors who trade only infrequently, as when they invest savings from their paychecks into index funds during their working years and withdraw them in retirement.
While index investors are satisfied with returns equal to risks, beat-the-market investors search for returns higher than risks. Some beat-the-market investors choose handfuls of investments and trade them frequently, hoping to fill their ladles with more fat returns than in the ladles of index investors. Others buy beat-the-market mutual funds, exchange traded funds, or hedge funds, hoping that their managers would find stocks with fat returns. But not all beat-the-market investors can be above average. The ladles of index investors are filled with average amounts of fat returns. If some beat-the-market investors fill their ladles with above-average fat returns, other beat-the-market investors are left with below-average fat returns in their ladles. Moreover, the expenses of beat-the-market investors are higher than those of index investors because beat-the-market investors pay higher costs of trading and the higher costs of beat-the-market managers. Beat-the-market costs are substantial. By one estimate, investors would have saved more than $100 billion each year by investing in low-cost index funds and foregoing attempts to beat-the-market by on their own or by paying money managers to do it for them.
The beat-the-market puzzle
Why don’t beat-the-market investors abandon their game and join index investors? One part of the answer is easy. While average beat-the-market investors cannot beat the market, some beat-the-market investors are above average. Professional investors, such as mutual fund and hedge fund managers, regularly beat the market. Stocks bought by beat-the-market mutual fund managers had higher returns than stocks sold by them. And hedge fund managers are famous for the billion-dollar paychecks they earn by beating the market. But investors in beat-the-market mutual funds trail investors in index funds because the costs of beat-the-market mutual funds detract from the returns passed on to investors more than managers add to them. Hedge funds are riskier than investors believe and the returns they pass on to investors are lower than investors believe.
Highly intelligent investors might be able to beat the market, but their success is far from assured because intelligent investors are not always wise. Harvard staff members are intelligent and so are Harvard undergraduate students with SAT scores in the 99th percentile as are Wharton MBA students with SAT scores at the 98th percentile. Staff and students received information about past performance and fees of index funds that track the S&P 500 Index. But the information about the funds varied by the dates when the funds were established and the dates when the funds’ prospectuses were published.
Wise investors faced with a choice among index funds following the S&P 500 Index choose the index fund with the lowest fees since these index funds are otherwise as identical as identical cereal boxes. But nine out of ten staff and college students chose index funds with higher fees and so did eight out of ten MBA students. Staff and students chased returns instead, choosing funds with the highest historical returns, apparently assuming that these offer returns higher than risks.
Insiders Deepen the Beat-the-Market Puzzle
Some investors have access to inside information, such as information about mergers being negotiated or disappointing earnings about to be revealed. Investors with inside information include corporate executives and investors with links to executives, including investment bankers and hedge fund managers. Members of Congress have inside information as well. Only one-third of American senators bought or sold stocks in any one year during the boom years of the 1990s but trading senators did very well. While corporate insiders beat the market by six percentage points each year on average, trading senators beat it by 12 percentage points. “I don’t think you need much of an imagination to realize that they’re in the know,” said Alan Ziobrowski, one of the authors of the study.
The success of insiders in the beat-the-market game only deepens its puzzle. Insiders fill their investment market ladles with above-average proportions of fat returns, while index investors fill their ladles with average proportions of fat returns. This leaves below-average proportions of fat returns in the ladles of outsiders in the beat-the-market game, even if we set aside the cost of playing the game.
A two-part solution to the beat-the-market puzzle
Why don’t outside investors quit the beat-the-market game? Why do investors search for money managers who would bring them ladles of beat-the-market returns even after managers have scooped expenses and compensation from the ladles? One part of the answer is in cognitive errors and emotions which mislead us into thinking and feeling that we or our managers can easily beat the market. The other part is in what we really want from our investments, including our desire to play the investment game and win.
Framing errors are some of the cognitive errors which mislead us into thinking that beating the market is easy. In particular, we fail to frame the investment market as a vat of investment stew where relatively high returns for one investor imply relatively low returns for another. You might object, noting that there are many investment vats rather than one. Some investment vats, such as the private equities vat, might have more fat returns in them than the vat of public equities. Private equity vats, unlike public equities vats, can be consumed only by large investors, undisturbed by hordes of small investors. Yet investors in private equities are far from assured that their managers would share the fat. Tom Perkins, a wealthy manager of a venture capital, tells about Harry, one of his investors, who asked him how he can live with the risk of his investments. “Well, Harry,” laughed Perkins, “it’s your money!”
Emotions join cognitive errors in persuading investors that beating the market is easy. Individual investors are often unrealistically optimistic, but they are regularly joined by professional investors who are flattered as sophisticated players just before they are fleeced. Lloyd Blankfein, the chief of Goldman Sachs, described investors who lost to Goldman at the mortgage securities game as sophisticated investors. But Phil Angelides, who questioned Blankfein at the Financial Crisis Inquiry Commission, said: “Well, I’m just going to be blunt with you. It sounds to me a little bit like selling a car with faulty brakes, and then buying an insurance policy on the buyer of those cars, the pension funds who have the life savings of police officers, teachers.” Jeff Macke, an investment advisor, elaborated: “Of course [Goldman Sachs traders] know more than the other guys,” he said to Paul Solman of PBS’ Newshour. And, if they’re selling it, well, you probably don’t want to be a buyer.” Macke failed to persuade Solman. “But pension funds don’t bring in the math whizzes, the quants, the people that Goldman Sachs has,” said Solman, “They’re no match for Goldman Sachs’ salespeople or traders.” Macke was ready when Solman was done. “Generally speaking, they aren’t,” said Macke. “So, what is a pension fund doing involved in these securities?” Unrealistic optimism is a likely answer. Pension fund managers believed that they had a realistic chance to win their game when, in truth, they were unrealistically optimistic.
What investors really want
J.H.B., the anonymous author of a 1930 book, Watch Your Margin: An Insider Looks at Wall Street, is speaking with W. E. Woodward, his friend:
“Do you know why people go into stock speculation?” asked J.H.B.
“To make money,” answered Woodward.
“Not at all,” said J.H.B., “They go in for the pleasure of getting something for nothing….What they want is a thrill. That is why we…drink bootleg whisky, and kiss the girls, and take new jobs. We want thrills. It’s perfectly human, but Wall Street is a poor place to look for thrills, for the simple reason that thrills in Wall Street are very expensive.”
J.H.B. was speaking in 1930, when Prohibition was the law, and whisky was bootlegged. The world has changed greatly since then, but our wants remain the same. Woodward is not entirely wrong. We do want to make money from investing and speculating. But J.H.B. is surely right. We want pleasure from investing and speculating, and we want thrills from playing the beat-the-market game and winning it. Wall Street is still a poor place to look for thrills and Wall Street thrills remain expensive, but we are willing to pay the price.
Investments offer three kinds of benefits: utilitarian, expressive, and emotional, and we face tradeoffs as we choose among them. The utilitarian benefits of investments are in what they do for our pocketbooks. The expressive benefits of investments are in what they convey to us and to others about our values, tastes, and status. Some express their values by investing in companies that treat their employees well. Others express their status by investing in hedge funds. And the emotional benefits of investments are in how they make us feel. Bonds make us feel secure and stocks give us hope.
Profits are the utilitarian benefits of winning the beat-the-market game, and cognitive errors and emotions mislead us into thinking that winning is easy. But we are also drawn into the game by the promise of expressive and emotional benefits. Indeed, we are willing to forego the utilitarian benefits of profits for the expressive and emotional benefits of playing the beat-the-market game and hoping to win that game.
Dutch investors care about the expressive and emotional benefits of investing more than they care about its utilitarian benefits. They tend to agree with the statement “I invest because I like to analyze problems, look for new constructions, and learn” and the statement “I invest because it is a nice free-time activity” more than they agreed with the statement “I invest because I want to safeguard my retirement.” German investors who find investing enjoyable trade twice as much as other investors. And a quarter of American investors buy stocks as a hobby or because it is something they enjoy.
Mutual Funds magazine interviewed Charles Schwab, the founder of the investment company bearing his name. Schwab said: “If you get… an S&P Index return, 11% or 12% probably compounded for 10, 15, 20 years, you’ll be in the 85th percentile of performance. Why would you screw it up?”
The interviewer went on to ask Schwab why he thought people invested in actively managed funds at all. “It’s fun to play around,” answered Schwab. “People love doing that, they love to find winners… it’s human nature to try to select the right horse. It’s fun. There’s much more sport to it than just buying an index fund.”
It is often hard to distinguish facts from cognitive errors and even harder to distinguish cognitive errors from wants of expressive and emotional benefits. We should empathize with fellow investors who do not share our wants. Some of us are passionate players of the investment game, willing to pay commissions for trades, subscriptions for newsletters that promise to foresee the market, and fees for money managers that promise to beat it. I empathize with their passions even if I don’t share them. Yet I see no benefit in cognitive errors and emotions that mislead us into sacrificing utilitarian benefits for no benefits at all. No benefit comes from playing the beat-the-market game because we fail to understand that it is difficult to win. And no benefit comes from failing to make wise choices among utilitarian, expressive, and emotional benefits. We can increase the sum of our benefits if we understand our investment wants, overcome our cognitive errors and misleading emotions, weigh the tradeoffs between benefits, and choose wisely.
“Well, Mr. Big Brother I.R.S. man, let’s try something different, take my pound of flesh and sleep well,” wrote Andrew Joseph Stack III before flying his plane into an I.R.S. office building, killing an I.R.S. employee and himself.
Anger over taxation by a foreign government was the cry of the 1773 Boston Tea Party where American colonists, animated by anger, tossed into the Boston harbor a shipload of tea taxed by the British government. Still, we do not like taxes even when imposed by our own governments. “I drive to work,” wrote one taxpayer. “I paid tax on the car I drive, the gas it uses, and on the maintenance to keep it up. At work, I earn money. This money is taxed by the state and federal government…I go out for lunch and guess what, it’s taxed as well…Should I die, taxed again…”
My mechanic sent a postcard offering “Tax Break Specials,” saving me the cost of sale tax. He must know that his typical customers prefer small savings in the form of a tax break to more substantial savings in the form of a cash discount. We dislike taxes so much that we are willing to pay $5,000 to save $4,000 in taxes. Imagine that you earn an annual salary of $50,000 before taxes at an American company. Now you are offered a position at one of two European branches at a $75,000 salary. The good thing about Country A is that your daily commute will be 60 minutes shorter than in Country B. The bad thing about Country A is that food would cost you $5,000 more than in Country B. Which country would you choose? Now imagine identical circumstances except that the bad thing about Country A is that you would pay $4,000 more in taxes than in Country B. Which country would you choose? Abigail Sussman and Christopher Olivola presented the first of the two circumstances to one group of people and the second to another group. It turned out that more people in the United States and Britain chose country B when they could save $4,000 in taxes than when they could save $5,000 in taxes. Sussman and Olivola asked people in their survey for political affiliations, placing Democrats, Communists and Socialists in the pro-tax group, and Republicans and Libertarians into the anti-tax group. They found that aversion to taxes characterized the anti-tax group but not the pro-tax one. Indeed, Democrats, Communists and Socialists were willing to endure a longer commute to avoid higher food costs than to avoid higher taxes.
- Brick, Michael (2010). “Man Crashes Plane Into Texas I.R.S. Office.” New York Times, 19 February.
- Comments to an article by Laura Sanders, “Rich Cling to Live to Beat Tax Many.” Wall Street Journal 30 December, 2009.
- Axe the Tax: Taxes are Disliked More than Equal Costs Abigail B. Sussman Princeton University Christopher Y. Olivola University College London Working paper 2010.
Behavioral finance is a framework that augments some parts of standard finance and replaces other parts. It describes the behavior of investors and managers; it describes the outcomes of interactions between investors and managers in financial and capital markets; and it prescribes more effective behavior for investors and managers.