I’m partway through What Investors Really Want, a brilliant new book by Meir Statman, Glenn Klimek Professor of Finance at the Leavey School of Business, Santa Clara University. In the book, Prof. Statman, an expert in the burgeoning field of behavioural finance, provides a framework for understanding the different motivations that investors have and the trade offs between them. I asked Prof. Statman for a short explanation of the concepts discussed at length in his book:
In your book, you point out that investors derive benefits from their portfolio other than mere utilitarian returns. Can you expand on what these benefits are?
The expressive and emotional benefits of a portfolio are many. For example, those who include in their portfolio derivatives express themselves as sophisticated. Those who pick stocks can express themselves as smarter than index-fund investors.
On the emotional side there is the pride of beating the market and the satisfaction in trading.
These emotional and expressive benefits of investments often detracts from utilitarian returns. But investors also derive enjoyment out of these benefits. How should investors balance the cost of these benefits against investment returns?
I think that investors should be aware of the costs and benefits and judge the tradeoff themselves. Is playing the game of beating the market enjoyable enough to justify the likely lag relative to the market? (Is hearing Placido Domingo in a concert hall worth the $100 price of the ticket?)
Even investors who are strictly seeking utilitarian benefits from their portfolio are often tempted by the emotional side. What can these investors do to keep their impulses in check?
Investors can keep their emotions from affecting their actions by setting rules – such as no trading. Or by appointing the spouse or advisor to prevent them from acting on emotions (as smokers who want to quit tell friends not to give them a cigarette even if they ask).