Tue, November 30, 2010
Meir Statman: Cognitive Errors Lead to Investment Mistakes
Today we're honored to participate in the Fall 2010 Blog Tour for Meir Statman's new book, What Investors Really Want, with a post written exclusively for the FFS Blog by Professor Statman.
Meir Statman is the Glenn Klimek Professor of Finance at the Leavey School of Business, Santa Clara University, and Visiting Professor at Tilburg University in the Netherlands and the author of What Investors Really Want (McGraw-Hill). His research on behavioral finance has been supported by the National Science Foundation, CFA Institute, and Investment Management Consultants Association (IMCA) and has been published in the Journal of Finance, Financial Analysts Journal, Journal of Portfolio Management, and many other publications. A recipient of two IMCA Journal Awards, the Moskowitz Prize for Best Paper on Socially Responsible Investing, and three Graham and Dodd Awards, Statman consults with many investment companies and presents his work to academics and professionals in the U.S. and abroad. Visit his blog at http://whatinvestorswant.wordpress.com/ .
Cognitive errors mislead investors
All of us are susceptible to cognitive errors which mislead us on our way to long term financial health. Hindsight errors urge us to be overconfident in our forecasts of the future because they mislead us into thinking that we knew in foresight what we know only in hindsight. Availability errors mislead us into thinking that finding mutual fund winners is easy because mutual fund companies advertize only their winners, making winners readily available to our minds. Here are some details about representativeness errors which mislead us into finding illusory patters as we seek real patterns and urge us to engage in market timing.
Imagine that we are facing machines with two levers marked S and B. The machines dispense nothing if we pull the wrong lever but they dispense $10 if we pull the right one. We’ll get to pull levers many times. A pattern is programmed into the machine, but we don’t know what it is. Perhaps it is a pattern in which the machines dispense $10 every time we pull the S lever and nothing when we pull the B one. Or perhaps it is a pattern in which the machines dispense $10 every second pull, regardless of the lever we pull.
How would we go about our task if we want to get the most money out of the machines? We look for patterns by trial and error. We pull the S lever and see if $10 is dispensed. Next we pull the B lever, or perhaps we pull the S lever again, until we find the pattern that will dispense the most money. It turns out that the pattern programmed into the machines is one where S is the generous lever and B is the stingy one. Both lever S and B dispense $10 randomly, but lever S dispenses $10 in four out of five pulls on average while lever B dispenses it on average in only one of five pulls. The winning strategy is to pull the S lever every time because this strategy is likely to dispense the most money. Pigeons rewarded by food find the winning strategy after a few trials and stick to it. But humans rarely stick to that strategy. Instead, we continue to try many strategies, switching between S and B until the game ends.
Now think of S as stocks and B as bonds. Stocks are the generous lever and bonds are the stingy one. Pulling the S lever every time is not sure to yield the most money, but it is likely to yield the most money. Similarly, stocks are not sure to yield higher returns than bonds even during periods extending into many decades, but stocks are likely to yield higher returns than bonds during long horizons. Smart investors with longtime horizons who want to maximize returns without regard to risk invest only in stocks, the equivalent to pulling the S lever every time. Smart investors who want to maximize returns but are also concerned about risk invest in both stocks and bonds in proportions corresponding to their desire for returns and aversion to risk. But we, normal investors, are often stupid. We regularly try to time the market, jumping from stocks to bonds and back again, accumulating less money on average than investors who buy and hold portfolios that combine stocks and bonds.