Should money funds be allowed to continue to price their shares by “buck” accounting, whereby the price of each share is fixed at one dollar? Or should they be compelled to price them by “mark-to-market” accounting, common to all other mutual funds, whereby changes in the market value of shares move their prices higher or lower than a dollar?
Today’s money fund agenda centers on mitigating systemic risks associated with money funds. These risks compelled the U.S. Treasury to offer a taxpayer guarantee on all money funds in September 2008, when the Reserve Primary money fund was forced to “break the buck,” setting the price of shares below a dollar.
A proposal to price money fund shares by mark-to-market accounting has been met with fierce opposition. Paul Schott Stevens of the Investment Company Institute wrote that “investors prize the stability, simplicity, and convenience” of money funds. David Hirschmann of the U.S. Chamber of Commerce wrote that investors would flee from money funds burdened by “the complexity and cost of accounting” of mark-to-market funds. And Kenneth White, a Chicago investor, threatened to liquidate his money funds if their prices were set by mark-to-market accounting.
We cannot understand the passions underlying the money fund debate unless we understand the psychology that underlies the attraction of buck accounting. That psychology centers on our cognitive errors of mental accounting and hindsight, and our emotions of regret and pride. An understanding of the attraction of buck accounting would help us overcome it.
Money funds were introduced in the early 1970s to circumvent regulations that limited the rate of interest banks could pay. They soon turned into substitutes for bank checking accounts. Money fund investors received checkbooks similar to bank checkbooks and could write checks for use everywhere. But money funds were not a close enough substitute for checking accounts because they lacked the “no-loss” psychological benefit.
Investors who deposited a dollar in a checking account were assured that they would be able to withdraw a dollar the following day, week, or year. But money fund investors had no such assurance. A dollar invested in a money fund one day might be worth 98 cents the following day. Investors who contemplated buying a television set for $500 would have had to withdraw 510 shares of the money fund if its share price declined from $1 on the day of the purchase to 98 cents when their check was cashed. The extra ten shares registered as a loss in the minds of money fund investors.
Investing, whether in a stock or a money fund, marks a hopeful beginning. We place a stock into a mental account, record its $100 purchase price and hope to close the account at a gain, perhaps selling the stock at $150. As stock fate has it, the stock’s price plummets to $40 during the following month rather than increase to $150.
Losses make us feel stupid. Hindsight error misleads us into thinking that what is clear in hindsight was equally clear in foresight. We bought the stock at $100 because, in foresight, it seemed destined to go to $150. But now, in hindsight, we remember all the warning signs displayed in plain sight on the day we bought our stock. Interest rates were about to increase. The CEO was about to resign. A competitor was ready to introduce a better product.
The cognitive error of hindsight is accompanied by the emotion of regret. We kick ourselves for being so stupid and contemplate how much happier we would have been if only we had kept our $100 in our savings account or invested it in another stock that zoomed as our stock plummeted. Pride is at the opposite end of the emotional spectrum from regret. Pride accompanies gains. We congratulate ourselves and feel proud for seeing in foresight that our $100 stock would soon zoom to $150. Mark-to-market accounting of money funds opens the door to both regret and pride every time we write a check, but regret is more painful than pride is pleasurable. It is no wonder that money fund investors prefer buck accounting over mark-to-market accounting, and money fund executives hear their voices.
In 1977, following much lobbying by mutual fund companies, the SEC approved the use of buck accounting such that the price of their shares remains at $1 even when the market value of the shares deviates from it. Managers of money funds promised not to “break the buck” and, at last, money funds seemed to have acquired the no-loss benefits of checking accounts.
The promise of managers of money funds not to break the buck was sincere but not guaranteed. The small print always said that the buck might be broken. Still, managers of money funds kept their promise for many years, on occasion paying from their own pockets so as not to break the buck. But when the financial crisis arrived in 2008 the managers of the Reserve fund announced that their fund contained securities of bankrupt Lehman Brothers and they must break the buck and set its shares to 97 cents. The development “is really, really bad,” said Don Phillips of Morningstar. “You talk about Lehman and Merrill having been stellar institutions, but breaking the buck is sacred territory.” This breaking of the buck was prominent among the events that led Henry Paulson and Ben Bernanke to recommend drastic measures, including government insurance of money funds, fearing the panic that would ensue if money fund investors raced to withdraw their money.
The demise of Reserve fund is ironic because Bruce Bent, one of its founders, opposed buck accounting when it was considered in the 1970s. Bent feared that buck accounting would compel money fund managers to buy risky securities in attempts to provide higher returns than their competitors. In a 1978 letter to the SEC Bent wrote that buck accounting “presents the illusion of higher returns in times of declining interest rates” and makes money funds “appear to have overcome the risk” of fluctuating interest rates. Bent noted further that buck accounting would encourage money funds to buy risky securities that “pay higher interest rates than those which must achieve stability by exercising judgment…” Bent vowed not to buy such risky securities, but he broke his vow under the pressure of competition. This is why the Reserve fund held Lehman securities when Lehman went bankrupt. What started as an attempt to turn money funds into no-loss investments ended with very real losses.
Jeffrey Lacker, President of the Federal Reserve Bank of Richmond, advocated mark-to-market accounting for money funds, noting that buck accounting promotes runs on money funds. I agree. Regret over losses is likely to seize money fund investors from time to time, but such regret is a small price to pay for a central block of a stable financial system.
The author of recent Buttonwood column in The Economist begins by telling us that “The demand for financial assets is not like the demand for iPods.” He or she notes that the desire for products such as iPods “may be driven by fashion or a desire to enhance our status.” In contrast, “Financial assets appeal for one reason only: their ability to enhance, or conserve, the buyer’s wealth.” Yet the author contradicts this distinction between iPod and financial assets in the next sentence, “There is nothing that induces a change in attitude as seeing a friend get rich.”
In truth, financial assets are very much like iPods. Pension fund managers were swept into private equity investments by fashion as much as by the prospect of profits. Who among pension fund managers would want to wear public-equity suits when the managers of the endowments of Yale and Harvard wear private-equity suits? And wealthy individual investors are drawn into hedge funds because they let them brag about their wealth without appearing to brag. “I’m into hedge funds,” they say to fellow dinner party guests, hinting that their wealth is in the millions. In contrast, “I’m into mutual funds” says that we have managed to scrape together the $3,000 minimum investment. Desire for status ensnared Bernard Madoff’s investors as much as desire for profits.
Moreover, what are profits for? We want the joy of being envied by our friends for getting rich rather than the sorrow of envying rich friends. We want to be number one and beat the market. We want to feel pride when our investments bring gains and avoid regret when they bring losses. We want the sophistication and status of hedge funds and the virtue and warm glow of socially responsible funds. We want to leave a legacy for our children when we are gone. And we want to leave nothing for the taxman.
Financial services companies understand well that financial assets are like iPods and advertize them accordingly. It is time for the rest of us to catch up.
I discussed some aspects of behavioral finance recently at a seminar for the investment professionals of a large investment company. In preparation, I presented to half of them the names and industries of several dozen companies and asked them to rate the future return of the stock of each company on a 10-point scale ranging from low to high. I presented the same list of companies to the other half and asked them to rate the risk of each stock on the same scale.
Standard financial theory predicts a positive correlation between expected returns and risk. The theory predicts that stocks rated high in expected returns would be rated high in risk. Yet this is not what I have found. Instead, I found a negative correlation. The investment professionals rated some stocks high in expected returns and low in risk, while they rated other companies as low in expected returns but high in risk. The perceptions of theses investment professionals are identical to perceptions of individual investors, as I found in a study with Kenneth Fisher and Deniz Anginer.
The perception of a negative relation between expected returns and risk is likely due to the ‘affect heuristic,’ described by Paul Slovic and his colleagues. We know affect in the finance literature as sentiment, where we speak about positive affect as positive sentiment and about negative affect as negative sentiment. Company names elicit sentiment, positive or negative. The names Google and Apple elicit positive sentiment, which attracts investors, whereas the names of Citigroup and Bank of America elicit negative sentiment, which repels investors. Companies with relatively positive sentiment tend to be growth companies with characteristics such as relatively low book-to-market ratios and relatively high market capitalizations. Companies with relatively negative sentiment tend to be value companies. Yet investor perceptions are driven by sentiment rather than by consideration of characteristics.
Companies which elicit positive sentiment are admired companies. Companies which elicit negative sentiment are spurned companies. Fortune magazine surveys executives and analysts each year and classifies companies along the admired-spurned line. Stocks of the admired companies in the Fortune surveys yielded lower returns, on average, than stocks of spurned companies. Investors who want high returns are wise to buy stocks of spurned companies. But I would offer no such advice to investors who know that facts of returns yet tilt their portfolios toward stocks of admired companies because they enjoy their glow. Enjoy!
Slovic, Paul, Melissa Finucane, Ellen Peters and Donald G. MacGregor (2002). “The affect heuristic,” Heuristics and Biases, Gilovich, Griffin and Kahneman eds. New York: Cambridge University Press.
Statman, Meir, Kenneth Fisher and Deniz Anginer (2008). “Affect in behavioral asset-pricing model,“ Financial Analysts Journal, vol. 64, no. 2 (March/April): 20 – 29.
Statman, Meir, “Investor sentiment, stock characteristics, and returns,” forthcoming in the Journal of Portfolio Management.