Posted by Tim Stobbs on December 13, 2010
Today’s guest post is by a very special guest, Meir Statman, who recently wrote a fascinating book called What Investors Really Want which looks to apply behavioral finance to our investing behaviors. Today he shares his views on people investing between hope and fear.
Hope for riches and fear of poverty always grip us, leading us to buy in hope and sell in fear. We frustrate ourselves and our financial advisors when we shift the balance between hope and fear. Our hope for riches grows when stock markets boom and our fear of poverty recedes.
We berate ourselves and our financial advisors for investing so much of our money in bonds that give us much freedom from the fear of poverty but little hope for riches. Our fear of poverty grows when stock markets go bust and our hope for riches recedes. Now we berate ourselves and our advisors for investing so much of our money in stocks that gave us much hope for riches but little freedom from the fear of poverty.
Financial advisors tell investors to rebalance their portfolios, reducing their investment in stocks after their prices increase and reducing their investment in bonds after their prices increase. But investors are driven by hope and fear to do the opposite. They increase their investment in stocks after increases in stock prices and decrease their investment in stocks after falls in prices. Increases in the uncertainty of stocks magnify fear and lead investors to pull money out of stocks, while reductions in the uncertainty of stocks magnify hope and lead investors to put money in stocks.
Hope and fear animate the normal behavioral investors of behavioral portfolio theory but they do not animate the rational investors of mean–variance portfolio theory. Moreover, whereas “mean–variance investors” consider their portfolios as a whole and are always risk averse, “behavioral investors” do not consider their portfolios as a whole and are not always risk averse. In the simple version of behavioral portfolio theory, investors divide their money into two layers of a portfolio pyramid, a downside-protection layer designed to protect them from poverty and an upside-potential layer designed to make them rich. In the complete version of the theory, investors divide their money into many layers—each of which corresponds to a goal or aspiration.
The pyramid structure of behavioral portfolios is reflected in the upside-potential and downside-protection layers of “core and satellite” portfolios. Schwab’s version of core and satellite combines a well-diversified Core to serve as the “foundation” layer of the portfolio and a less-diversified Explore layer to seek “returns that are higher than the overall market, which entails greater risk.”
Behavioral investors consider the individual stocks they hold as part of the upside- potential layer of their portfolios and are willing to forgo the benefits of diversification in an attempt to reach their aspirations. The desire of investors to attain their upside-potential aspirations leads them to take higher risks in these layers than they take in the downside- protection layers. For example, their aspirations lead investors to buy aggressive growth funds, individual stocks, and call options, all of which have positive expected returns accompanying their high risks. Moreover, at the extreme, the desire of investors to reach their aspirations leads them to buy lottery tickets and participate in other gambles that have negative expected returns.
Investors do not gamble because they seek risk. Rather, they gamble because they badly want to reach their aspirations. Some gamblers, thinking that they have positive expected returns, misjudge the odds of their gambles, but other gamblers know the odds and gamble nevertheless because gambles with negative expected returns offer them the only chance to reach their aspirations. In that behavior, they are similar to the investor who is in a casino with $1,000 and desperately aspires to have $10,000 by morning. The “optimal portfolio” for this investor is concentrated in a single gamble, one that offers a chance, however small, of winning $10,000. Investors who diversify their gambles are less likely to succeed than the investor who concentrates them because diversification provides virtually no chance of winning the aspired $10,000.
Investors, financial advisors, and companies sponsoring pension plans must be careful to draw a line between upside potential and downside protection in such a way that dreams of riches do not plunge investors into poverty.