Thanks to Kees Koedijk and Alfred Slager for this guest post. Visit their blog here.
Top 10 stocks and funds to invest in for 2011 circulate widely. It’s a recurring theme with a predictable storyline at the end of the year. The analyst: “Well, we indicated that stock XYZ should be the best performing one this year, and it should have been the case, but it has not for good reasons.” Analysts then borrow the “deus ex machina” plot device from the theatre (literally, “God out of the machine”), in which a seemingly inextricable problem is suddenly and abruptly solved with the unexpected intervention of some new character. For analysts this usually boils down to central banks not behaving like they should, politicians meddling with economics or misplaced optimism or pessimism of consumers or companies.
So unless the investing public suffers from collective amnesia with a yearly cycle, the real merit of predicting is not the prediction itself. Maybe it’s a form of mating game in the investment industry. The analyst, bank or mutual fund signals with his prediction to the investor that he knows the intricate details of financial markets, and is therefore fully in control of the risks attached to an investment. And once you’re in control of the risks, then there is actually no risk attached, is there? An elegant way to play into investor’s permanent desire for free investment lunches, an important theme in Meir Statman’s insightful book “What Investors Really Want”.
Maybe institutional investors and pension trustees should be given a second chance for better New Year’s resolutions. If they’re smart, they won’t focus on predictions, but on understanding why predictions continually fail, and how to benefit from this insight. This requires delving more into the beliefs behind the economic theories, and how they affect your investment decisions, the central theme of our recently published book Investment Beliefs. A Positive Approach to Institutional Investing. The problem at hand is quite simple. Despite all the research done and money spent in the financial industry, diverging views persist in economics and finance. A solid theory, broad dataset and sound research methods should be able to resolve ongoing debates and lead to accurate predictions. Economists and researchers surely put an enormous effort into research, but resolving debates tends to move slowly. Economics and finance are tough subjects to investigate. Why is this?
A historic perspective comes in handy. Investing theory and practice have developed dramatically over the past five decades, yet as Andrew Lo argues, there still is no objective framework around for viewing capital markets and deciding how to apply these insights for investment purposes. Active management, passive management, absolute return strategies – all are different views of capital markets that happily co-exist. Yet none can be pinpointed as the right one. Theories in investments and finance simply do not have the same degree of confidence as theories in physical sciences. The main theories have not been road tested; basic premises are not conclusive. For example, is there any agreement on whether financial market pricing is efficient; the basis for passive management? Research findings are inconclusive. There is an increasing amount of evidence on “anomalies”, unexplained gaps between predictions and realizations. However, no workable alternative for the underlying theory has been formulated that can be put to good use on a large scale. Moreover, few investors are actually able to exploit these “anomalies” and turn them into higher returns.
So in the meantime, students and investment managers learn that efficient pricing exists, but observe and act otherwise in practice. Believers in inefficient markets usually invest in what they perceive as undervalued stocks, sectors or assets, and do appreciate market-timing. In a brilliant stroke of marketing, they have labeled themselves as “active” managers, ideally positioned for investors who want to be in control and want to win. Believers in efficient markets on the other hand focus on buying the index against the lowest costs possible: costs are after all a certain drag on your returns, while the free investment lunches pictured by the active managers have yet to materialize.
This discussion suggests that the smart, rational money is on passive investing. The reality is the other way around. The overwhelming share of equities is invested by active managers. Our experience is however that pension funds would make fundamentally different choices if they were aware of the uncertainties behind the economic and finance theories – after all, it boils down to what you believe in. We call this investment beliefs: an explicit view on how to interpret, and approach a debate in the financial markets. We covered active versus passive management as a noteworthy investment belief, but there are many other beliefs out there: on sustainability, risk premium, investment horizon, risk management- to name a few.
Investors simply have to deal with the fact that many debates never really reach a firm conclusion and keep haunting them. Proponents of active management have just as much ammunition in the form of anecdotal evidence or research to prove their case to sympathizers of passive management as the other way round. There is no single objective truth in the financial markets, just an accumulation of learning by doing and adapting to new realities. Investment beliefs address this uncertainty and make it manageable – not predictable.
So, chances are that the predictions will once again miss the mark. This shouldn’t worry investors, and certainly not prevent us from filling out the sweepstakes. The process of arriving at a prediction might well be more important than the prediction itself. Wouldn’t that be a great way to actually realize a New Year’s resolution?
“In anxious times people seek cover in gold,” wrote the New York Times in November 2010, as the price of an ounce of gold crossed the $1,400 bar. “People are coming in to buy 50 or 100 coins at a time, which is hefty for individuals,” said a coin broker. “It’s not just rich people, either. A lot of people are putting 30 to 35 percent of their net worth in gold; they are scared to put money in paper assets. ”
Fear is driving up the price of gold yet there is reason for fear. It was not long ago that we have lost almost half of the value of our stocks, unemployment is still hovering around 10 percent, budget deficits are huge, money is printed in enormous quantities, and currency wars are brewing. Still, even a gold-bull is concerned that the price of gold has shot too high. “It’s beginning to smell a little like the beginning stages of a bubble,” he said.
We are all gripped by fear from time to time, yet fear is not a good investment guide. Few accidents are more horrifying than airplane crashes, yet the fear elicited by such disasters depresses stock beyond reason. Aviation disasters cause actual losses lower than $1 billion on average, but the loss in the value of stocks following an aviation disaster averages more than $60 billion.
We are less willing to take risk when we are frightened than when we are calm. In one experiment, a group of students were offered money to stand before the class the following week and tell a joke. A flat joke can be embarrassing, so it is not surprising that some students who agreed to tell a joke withdrew in fear when the time came to stand and tell a joke. But students who were frightened were more likely to withdraw than students who were not. Half the students in the experiment were shown a fear-inducing film clip from The Shining, Stanley Kubrick’s classic horror film, before deciding whether to tell a joke or withdraw. It turned out that a greater proportion of them withdrew.
Fear misleads us to avoid risk even when it is wise to take risk. Here is an investment game: I’ll toss a coin right before your eyes. If it comes out heads, I’ll pay you $1.50. If it comes out tails, you’ll pay me $1. We’ll play 20 rounds of this game. Before each round you can choose to participate or sit it out. Ready? Suppose that you have lost three dollars in the first three rounds because all three tosses came out tails. Do you choose to participate in the fourth round or do you choose to sit out?
Three losses in a row would arouse fear in normal investors. Many choose to sit out the fourth round. But there is no good reason to be afraid because the game is stacked in favor of those who play all 20 rounds. In each round we have a 50/50 chance to lose $1 or gain $1.50. Our maximum loss is $20 while our maximum gain is $30. And even if we lose, a $20 loss is hardly catastrophic. Yet brain-damaged players were more reasoned at the game than normal players. Undeterred by fear, brain-damaged players played more rounds of the game than normal players and won more money.
There is a lesson here for normal investors. Fear grips us when we watch our portfolios day by day and see so many losing days. Fear grips us even more strongly when we watch losses in our portfolios over many months or even years, as happened in 2008 and early 2009. Fear urges us to sell our stocks and invest the money in gold or put it under a mattress. Our emotional response is normal, but it gets in the way of wise behavior.
- Guy Kaplanski and Haim Levy, “Sentiment and Stock Prices: The Case of Aviation Disasters,” Journal of Financial Economics 95 (2010): 174–201.
- George Loewenstein, Elke Weber, Christopher Hsee, and Edward Welch, “Risk as Feelings,” Psychological Bulletin 127, no. 2 (2001), 267–286.
- Nelson Schwartz and Graham Bowley, “In anxious times, investors seek cover in gold,” New York Times, November 10, 2010, p. A1.
- Baba Shiv, George Loewenstein, Antoine Bechara, Hanna Damasio and Antonio Damasio, “Investment Behavior and the Negative Side of Emotion,” Psychological Science, vol. 16, no. 6 (2005): 435-439.
- Meir Statman, What Investors Really Want, McGraw-Hill, New York, 2011
Think of an investor who had a $2 million portfolio in October 2007, $1 million in bonds and $1 million in stocks. Visit him again in February 2009 when his bonds are still worth $1 million but his stocks are worth only $500,000. What should he do now? Should he re-balance his portfolio? And, if so, how should he re-balance?
The initial portfolio was a 50/50 stock/bond portfolio and the standard advice is to re-balance back to a 50/50 portfolio by selling $250,000 worth of bonds and using the proceeds to buy $250,000 of stocks. This advice flows from two distinct reasons, one related to risk tolerance and the other to expected returns.
The risk tolerance reason is that an investor who has chosen a 50/50 portfolio has declared that his risk tolerance corresponds to an optimal 50/50 portfolio. The February 2009 portfolio is a 33.3/66.7 stock/bond portfolio, so it is sub-optimal. The portfolio can be made optimal again by restoring it to its 50/50 proportions.
The expected returns reason is that securities returns tend to be mean-reverting, so it is likely that the returns of stocks would be high relative to their long-term mean following periods where their returns were low relative to their mean, and the same is true for bonds. If our world of returns is a mean-reverting world then investors benefits by buying stocks just before their returns are especially high and selling them just before their returns are especially low. In a recent exchange of letters to the editor of the Financial Analysts Journal, William Bernstein argued that our world is a mean-reverting world while William Sharpe argued that it is not clear that this is our world.
The re-balancing answer of behavioral portfolio theory is quite different from these two answers. The investor with a $2 million portfolio chose to invest $1 million in stocks and $1 million in bonds because he has two distinct goals reflected in two mental accounts or “buckets.” Being-rich is one goal, and that is the purpose of the $1 million in stocks. Not-being-poor is the other goal, and that is the purpose of the $1 million in bonds. We can think of the not-being-poor goal as the goal of retirement at a basic level of comfort. We can think of the being-rich goal as the goal of enjoying luxuries in retirement or leaving a substantial bequest to children or charity.
A “behavioral investor” might well object to selling bonds from his not-being-poor mental account because the proceeds of such sales might be lost if invested in stocks, diminishing his basic level of comfort in retirement. Our investor has good reason to refuse the usual re-balancing advice and financial advisers should listen to him.
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.
The life of the Office of Thrift Supervision comes to an end now that the financial regulation bill is law. The end of the life of the Office is overdue, but its life illustrates the problem we face as we appoint regulators to protect us from financial institutions, oil companies, pharmaceutical companies, and all other interest groups. George Stigler, a University of Chicago economist and Nobel Prize winner called it the “capture” problem. We, the general public of individual investors and consumers, hope that regulators would fight for us against the interest groups of bankers, lawyers, union members and employers. But regulators are more likely to be captured by interest groups, treating interest groups as customers and constituents to be served rather than as potential regulation-breakers who should be policed. “Our goal is to allow thrifts to operate with a wide breadth of freedom from regulatory intrusion,” said James E. Gilleran in 2004, while serving as the director of the Office. John M. Reich, who directed the Office in 2007, canceled a scheduled lunch so he might have lunch with Kerry K. Killinger, the chief executive of Washington Mutual. “He’s my largest constituent,” Mr. Reich wrote.
Politicians have the power to direct regulators to act in the public interest, yet they feel compelled to let themselves be captured by interest groups which provide contributions to campaigns which keep politicians in office. Regulators do not need campaign contributions but they let themselves by captured in return for favors while in office and lucrative industry jobs once they leave office. The general public has ultimate power over politicians and regulators since it votes politicians into office or boots them out. Yet the general public rarely exercises its power when placated by economic booms and rising financial markets which reduce its vigilance. Yet recessions and collapsed financial markets outrage the general public, increasing its vigilance and its clamor for regulatory protection from interest groups.
Outrage shifts power to the public as politicians can garner more votes from an enraged public than they can buy with contribution from interest groups. President Obama and the Democrats harnessed public outrage to propel the new financial regulation law. While the law includes many parts, Obama aimed the spotlight at the consumer protection agency in a speech before signing the bill into law. He highlighted practices which enraged the public and would now be outlawed, including hidden fees in mortgages and tricky financial disclosures. “All told, these reforms represent the strongest consumer financial protections in history,” Obama said. “And these protections will be enforced by a new consumer watchdog with just one job: looking out for people — not big banks, not lenders, not investment houses.” Republicans have argued that substantial portions of the new law, especially the new consumer protection agency, have little to do with the financial crisis. That argument is true, but it misses the point. The financial crisis whipped public outrage and Obama and the Democrats harnessed the outrage rather than waste it.
Public outrage will subside as the economy and financial market recover, bankers and other interest groups will regain their power to capture politicians and regulators, and so it will be till public outrage swells again in the next crisis.
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.