Meir Statman is the Glenn Klimek Professor of Finance at Santa Clara University and one of the leading researchers in the field of behavioural finance. His research has been published in the Journal of Finance, Journal of Financial Economics, Review of Financial Studies, Journal of Financial and Quantitative Analysis, Financial Analysts Journal, The Journal of Portfolio Management and many others.
In his latest book Finance for Normal People: How Investors and Markets Behave, he looks at what behavioural economics has called “irrational” and instead describes this as “normal.” It’s not that people make “stupid decisions,” but rather, it is that they engage in “normal human decision-making.” That leaping off point leads to a way of thinking about investing that is quite different than most other investment psychology.
According to the author, normal people are not irrational. They do not go out of our way to be ignorant or commit cognitive and emotional errors. Instead, they are ‘normal-foolish,’ misled by cognitive errors such as hindsight and overconfidence, emotional errors such as exaggerated fear and unrealistic hope.
In conversation with Christine Benz, Morningstar’s director of personal finance, he discusses first and second generation behavioural finance. Here is an excerpt from that conversation.
In standard finance, people are rational, computer-like rational.
In the first generation of behavioural finance we turn them into irrational bumbling idiots subject to all the long list of cognitive and emotional errors. And I think that we went too far. We overdosed on those cognitive errors, and it is time to really move to the middle and describe us as we are, normal people, normal knowledgeable and normal ignorant, normal smart and normal stupid, but intelligent enough to learn and to increase the ratio of smart to stupid behavior.
Let me give you an example about lottery tickets.
Standard finance says rational people don't buy lottery tickets.
First generation of behavioural finance said, irrational people buy lottery tickets. Why? Because they don't know statistics and the mathematics.
Second generation of behavioural finance says people buy lottery tickets because they want hope of being rich. The group that buys the most tickets or most frequently are people between the ages of 60 and 69, perhaps because this is an age where they realize that they cannot become physicians now or start the next Google and so on and so their chance really is in getting lottery.
Suppose you told somebody who does not know statistics that the odds of winning are not 1 in 100 million as he thought but 1 in 200 million. Would that person now not buy a lottery ticket? Of course not. It is just that smidgen of an opportunity between no chance and some chance that is giving people that urge to buy lottery tickets.
This is what the second generation of behavioural finance does-- begin with what people want. People want utilitarian, expressive, and emotional benefits in everything that we buy and use. And so, a lottery ticket has the emotional benefit of hope; it has the expressive benefit of, I am a player, I'm in the game; and of course, it has possibly the utilitarian benefits because somebody can win. You might actually win.
But from that you can get all the other wants. What is wealth for? It is for well-being. It is for satisfying our wants. And so, for some people, it means being true to their values and excluding stocks of companies they disapprove of for one reason or another.
All of us crave respect and high social status. And so, we buy hedge funds. Of course, we say that it's for the returns and low risk, but I think that you just get into a casual conversation of investments and if you say to people that you are into hedge funds, they immediately know that you are rich without you having to say that. And we want to take care of our kids and we feel pride in doing that.
You have to begin first with what it is that we want and then realize that we do make mistakes on the way from where we are to where we want to go to achieve our goals. But we don't do it because we are bumbling. We are doing it because we might be ignorant of how to do it better.
It is useful to think of people as normal, sometimes normal smart and sometimes stupid, and really figure out ways to satisfy all of those normal wants in ways that give them the highest level of well-being.
I hope that the book in many ways is going to help people figure out that distinction and not abandon their goals but find better ways to achieve them.
