Interview with Professor Meir Statman: Noted Authority on Behavioral Finance Explores Distinction People Make Between Capital and Income; Seeks to Bring Gaps Between Theory and Evidence Closer Together
Meir Statman’s research focuses on behavioral finance. He attempts to understand how investors and managers make financial decisions and how these decisions are reflected in financial markets. The questions he addresses include: What are the cognitive errors and emotions that influence investors? What are investor aspirations? How can financial advisers and plan sponsors help investors? What is the nature of risk and regret? How do investors form portfolios? How important are tactical asset allocation and strategic asset allocation? What determines stock returns? What are the effects of sentiment?
Professor Statman’s research has been published in the Financial Analysts Journal, The Journal of Portfolio Management, The Journal of Finance, and many other leading journals. He is a member of the Editorial Board of the Financial Analysts Journal, the Advisory Board of The Journal of Portfolio Management and the Journal of Investment Consulting, and is an associate editor of several other professional journals. The recipient of a Batterymarch Fellowship and two Graham and Dodd Awards of Excellence, Professor Statman has consulted with many investment companies and presented his work to academics and professionals in many forums in the U.S. and abroad.
Macchia – Meir, to begin, would you describe your position at Santa Clara University, and, in general terms, the focus of your work?
Statman – I hold the Glenn Klimek Chair as the Professor of Finance at the business school of Santa Clara University. My work, broadly, is in behavioral finance, and behavioral finance is quite broad itself. Behavioral finance describes the financial behavior of investors, managers and consumers, such as saving, trading, and portfolio formation. It describes the interactions among investors, managers and consumers in financial and capital markets. And it describes how such interactions determine stock prices and trading volume. It also prescribes more effective financial behavior to investors, managers and consumers.
Macchia – Meir, what sparked your interest in behavioral finance? I mean, going back to your earliest decision to research in this area.
Statman – There was no behavioral finance when I started working on behavioral finance. I was attracted to it by what we know formally as ‘critical thinking,’ that is, putting theory and evidence side by side and seeing whether they fit.
An experience that sparked my early research relates to the distinction people make between income, such as dividends, and capital.
As students of finance know, Merton Miller and Franco Modigliani proved in 1961 that it is not rational to distinguish dividends from capital. I studied that in the late 1960s at the Hebrew University of Jerusalem. The theory makes sense. If an investor does not receive a dividend check she was expecting she can sell a few shares to generate ‘homemade dividends’ in an amount equal to what she would have received in a dividend check.
I came to New York in late August 1973 to study for my Ph.D. at Columbia University, just before the Yom Kippur War of October 1973 and the Arab embargo that followed. Oil prices zoomed, lines formed at gas stations and Con Edison, the utility company of New York, eliminated its dividend. The Con Ed shareholder meeting in 1974 was a riot. Elderly people screamed about the loss of dividends and some were ready to string Con Ed’s Chairman on a wire.
The facts of the shareholder reaction did not conform to theory. Why were Con Ed shareholders so upset? Why didn’t they simply create homemade dividends by selling a few Con Ed shares?
The discrepancy between theory and evidence stayed with me and later on, in 1980, along with my colleague Hersh Shefrin, I could see the connection between my observations and the work of psychologists Daniel Kahneman and Amos Tversky about cognitive biases and prospect theory, self control and regret.
I could find in that and similar work tools that not only enable me to see gaps between theory and evidence, but also bring the two closer together.
Macchia – Interesting. Meir, would you say that, then, in terms of what we describe as the field of behavioral finance, that you are the seminal individual in developing that field?
Statman –I was among the early ones but I surely was not the only one. The early group of economists and financial economist included Richard Thaler, Robert Shiller, Hersh Shefrin, myself and very few others .
Macchia – Thank you for clarifying that. I looked at some information about you on the web and , of course, I’ve heard you present. Wealth2k had the honor of sponsoring one of your wonderful recent addresses.
Statman – And I thank you for that.
Macchia – You’re welcome. This occurred at RIIA’s 2007 Managing Retirement Income Conference, and it was just a wonderful address that you gave. I know that some of the research questions that you focus on are actually specified on your website and I’d like to ask you about a couple of them. One of the issues that you deal with is the cognitive issues and emotions that influence investor behavior. Could you talk a bit about what you’ve uncovered in your research?
Statman – The cognitive biases have been uncovered by psychologists such as Daniel Kahneman, Amos Tversy, Paul Slovic and Baruch Fischhoff. What I have done is to ask whether these provide insights into the behavior of investors and managers. Let me illustrate with hindsight bias, a favorite of mine.
We all experience hindsight in our daily lives. It is the sense that what we know in hindsight we could have also known in foresight. The controversial example I’ll provide is not from finance, but from 9/11. Today, in hindsight, it is absolutely clear that all of the signs of the attack were obvious before 9/11 to anyone who bothered to look. But hindsight is not foresight. What we know at the end of a mystery novel we did not know a few pages before that end.
Once the stock market’s 2000 crash came it was absolutely clear that it was going to come. But if you actually look at the record you find that the famous Greenspan “rational exuberance” speech was in 1996, not in 2000. Look at pre-2000 issues of the Wall Street Journal and you’ll see that at any time there were people who said that the market would go up, and people who said that it would go down. What was clear in 2000 was not clear in 1996.
Hindsight causes us a lot of grief because it makes us feel stupid. “Why didn’t I get out of the stock market in 2000?” And yet hindsight gives people the confidence that can tell the future as easily as they can tell the past. So people try to time the market and usually end with more chagrin than joy. They finally decide to get out of the market in early 2003 when the market was at low and come back in 2007 when it is higher.
Macchia – You bring up something that I’ve found very interesting for many years, and I’ve often quoted the statistics that are published annually in DALBAR’s Quantitative Analysis of Investor Behavior, where the focus is on mutual funds, and the actual mutual fund returns that individuals realize compared to the S&P 500. What typically seems to happen is that over 20 year periods of time, the individuals underperform the index by perhaps 800 or 900 basis points.
Statman – The DALBAR numbers are exaggerated, but better studies show that investors underperform by 150-200 basis points per year because of poor market timing decisions. That is quite a lot. That is more than most financial advisors charge for their services. Advisors earn their fees easily if they only prevent clients from doing foolish things, like timing the market.
Macchia – Let me ask you about another topic that I know you’ve studied a great deal and that is insurance and annuities, and some of the reasons that they are arguable underutilized by individuals. What would your views be in terms of explaining why this occurs?
Statman – It is a fairly complicated problem, as you must know. Why don’t people annuitize their capital, when this seems the rational thing to do? After all, annuities provide income for life, eliminating the risk that we might run out of capital. I think that people stay away from annuities for psychological reasons. For example, people have difficulty with problems that involve money over time. An immediate annuity that pays $80,000 per year might cost $1 million. That annuity might be fairly priced, but it is hard for a man who sees himself as a millionaire to come to terms with the fact that today’s upper class million is worth no more than a mediocre middle class income of $80,000 per year.
Another psychological barrier is the distinction people make between capital and income. I mentioned it earlier in connection with dividends. People follow a rule of “consume from income but don’t dip into capital.” An immediate annuity is a clear form of dipping into capital and people are reluctant to engage in it.
Macchia – Let’s talk about another risk- the loss of one’s life. In the event of untimely death, life insurance is uniquely able to provide a large sum of money to beneficiaries in return for a relatively nominal amount in terms of the premium for the policy. It’s a big multiplier effect that over many years has provided the safe harbor for many families. It’s saved many families from financial ruin, yet most would agree that life insurance is underutilized and underappreciated. I have my own theories about why that might be and I’m wondering if you have some ideas?
Statman – I think that life insurance makes a lot of sense for many people such as those who are supporting children. Loss of life of parents is always a disaster for children but the disaster is compounded if money disappears as well. So why don’t all people who should buy life insurance buy it? There are really many reasons from, “I don’t think it’s going to happen to me” to “I don’t have the money for that.” People are motivated to buy insurance against hazards that are scary. Dying is scary but not as scary as dying of cancer or dying in an airplane crash. So some people are willing to buy insurance against dying of cancer or dying in an airplane crash while they are less ready to buy plain life insurance that covers these two causes of death and all other ones.
Macchia – Meir, I’m wondering if you think that there’s a role for life insurance for people who earn higher than average incomes, for whom, for instance 401(k) deferrals may be insufficient in order to set up enough retirement income. Life insurance in terms of say a variable universal life policy offers growth potential and the access to cash through policy loans is income tax free. Do you think that combination of benefits may make sense for some people who are looking for other, supplemental ways to create retirement security?
Statman – I wonder if combining elements of savings and insurance makes sense. Term life insurance covers the risk that an income earner might leave a family with no income at the early stages of life when wealth is low. Saving can be done separately. Separation of insurance from savings reduces complexity and there have been many stories about how complexity has been used to hide pretty high fees.
Macchia – Meir, I’d like to shift gears and ask you a couple of personal questions. These questions are a consistent theme in these interviews and I find them to be ones that generate some fascinating answers.
The first question is this: If I could somehow convey to you a magic wand and by waving this magic want you could affect any two changes relative tin they world of financial services that you wish to make, any two things at all, what would they be?
Statman – Good financial advisors are like good physicians. They know the science of finance as physicians know the science of medicine, but they also have a human touch. They listen, empathize, diagnose, educate and treat. Most physicians do just that, and so do most financial advisors. But not all do that. If I could have a magic wand I would use it to direct all the energies of advisors to their clients and all the energies of physicians to their patients.
Macchia – Next question: If you were not the Glenn Klimek professor of finance at Santa Clara University, but instead could hold any position in any other field, what would that be?
Statman – I really am one of those fortunate people who are in the right position. My work is varied and deeply satisfying. I get to write, do research, teach, interact with fellow scholars and practitioners like you, learning a lot from those interactions. Happiness comes with autonomy, contributions to others and the ability to develop one’s skills. I surely have all three. I pretty much control my time, have wonderful interactions with students, colleagues and practitioners, and I always push myself to examine new problems and engage in new projects.
Macchia – Not a bad life.
Statman – Not a bad life at all. I could have enjoyed a similar life as a scientist in many fields but surely not as a politician. Politicians must bend the truth to satisfy constituents. I would find it difficult to do.
Macchia – Well, you clearly made the right choice. I noticed that you didn’t say psychologist.
Statman – No, I don’t think that I would want to be a practicing psychologist. I don’t think that I would want to be a practicing financial advisor either. Advisors get a lot of gratitude from investors, and my sense is that the best clients are like my best students. I would enjoy educating them. But I don’t know if I would have been able to keep my cool in meetings with clients who complain that while they have done okay, Joe, their neighbor, has done better. I would probably say something that would make them clients of somebody else.
Macchia – I love your answer and here’s the last personal question: You’re 60 years old. I’d like you to imagine your own retirement in its most conceivably perfect form, where will you be and what will you be doing?
Statman – I have a boring answer, I’m afraid. I’ll be right here where I am and doing exactly what I have been doing for as long as my body and mind allow me. More generally, I see two groups of people. People like me who answer quite truthfully that they would retire only when they die and people who choose to retire at 62 when they can qualify for social security. I understand that different people have different circumstances and preferences but I feel sad for the second group.
Macchia – Your answer is remarkably similar to the one that I got from Moshe Milevsky. What came through to me in his answer was the passion that he has for teaching. He said that he wants to be teaching until his last moment. You didn’t say exactly that, but is it similar to you in terms of the teaching?
Statman – No…I wouldn’t say that. I think that teaching is satisfying, and I enjoy it. There is a wonderful sense when you leave the classroom and you see in the eyes of the students that they have learned what you were trying to teach and found it useful and stimulating. But teaching can become routine. I like to find and propagate new ideas. When I was little my mom would say, “Whatever people say, Meir, you must say the opposite.” She would say it with equal parts of pride and exasperation. I was a generally agreeable child and I’m a pretty agreeable adult today, but I continue to say, “Wait a minute. They say that this is true, but perhaps they are wrong.” There is special joy in overturning accepted truths. That joy animates me that I hope I will never lose it.
Macchia – I hope so too. And thank you. You just made me feel better about my 7 year old son’s future.
Statman – Exactly. Don’t raise conformists. By the way, I don’t know if you agree or if it has room in the interview. I think that parents today are fearful about the future and raise their kids in a regimented way that reflects that fear. I am optimistic about the future. I think that parents, I am one, need to lighten up, listen to kids and guide them with a lighter hand.
Macchia – That is really good advice. I’ve recently read Walter Isaacson’s wonderful book on Einstein. Einstein is someone who I’ve read about and is a personal hero of mine for many reasons. Einstein’s inclination to always challenge conventional wisdom, challenge authority and be an independent thinker is the notion that you’ve been describing. It certainly did well by him.
Statman – I admire Einstein even though physics is beyond me. I like science but I’m especially interested in science about people, such as biology and neurology, not in science about the physical world, such as geology or physics.
Macchia – I don’t know if you perhaps have 5 more minutes that you can give me for the exploration of another topic. This is in regards to the research that you’ve done, which I gather is a favorite subject and I’m interested to know, that is researching the investment performance of companies that are admired versus despised. You’ve recently co-authored a paper on this and I’m sure it’s not the first paper. How did you get on this topic and what did you find out of the research that you did in this area?
Statman – I started with this project many, many years ago. In fact, the first Fortune survey of admired companies appeared in 1983 and I read it and said, “Wow. Let me check if the most admired companies provide the highest stock returns.” My guess was that they provide the lowest returns because investors become enamored by admired companies and push their stock prices too high. That is what I found later in my research. But what is generally true is not true with every stock every day. In 1983 I put $5000 into 3 stocks that were least admired in the Fortune survey. I held them for a few months, maybe a year. Their performance was absolutely terrible. Eventually I managed to find the courage to realize my losses and move on. It surely taught me a lot about diversification and about the difference between short time horizons and long ones.
Macchia – Meir, I can’t thank you enough, for taking so much time, being so forthright in your answers and providing so much insight. This has been a real treat for me.
Statman – You are very, very kind. I really enjoyed speaking with you and hope that we will continue to keep in touch.
©Copyright 2007 David A. Macchia. All rights reserved.