Main Street is yet to come to grips with the mean machine called markets, behavioural finance expert Meir Statman tells Rajesh Padmashali. His advice to the average investor who can’t keep off trading: sin moderately
“Never underestimate the power of stupid people in large groups.” Is that saying very familiar to a practitioner of behavioural finance?
Yes, of course, but I have more empathy for people than you seem to. Standard finance assumes that people are rational and never stupid. The truth is, we are neither rational nor are we the irrational bumblers that behavioural finance makes us out to be. Generally, we are very smart, sometimes we are stupid and the task we have is distinguishing what is really stupid from what is smart. Understanding what is smart and what is stupid depends upon what it is that you want.
The task I see for people like me is to say, ‘I know what you eventually want. You want to support your children, retire comfortably and feel like a person of high status.’ And the desire for status is not limited to the richest. Everybody cares about status, even academicians — we care about how many papers we have published, in what journals and so on. Unfortunately in both, standard and behavioural finance, the assumption is that the goal is the same — get the highest return as quickly as possible.
Is that why there is too much short-term trading in the market?
People trade too much because they do not understand the nature of the game. If you buy a stock thinking the price is going to go up, you have to ask yourself who is the idiot who is selling it. Because, in every trade there is an idiot and, if you don’t know who it is, it is you. The opponent might be more skilled than you, have information you don’t have, be tipped off by an insider and, so, when I feel like trading I ask myself, who is the idiot on the other side? What is my relative advantage? The answer is ‘nothing’, so I don’t trade.
But some people find trading exciting. To them I say, ‘If you are going to sin, do so moderately. Don’t eat into your retirement money or your kid’s education fund.’ Some people will resist this message because they think they have extra skills or perhaps they are overconfident. The game of the market is not crooked. It is simply the game and if you don’t understand it, you are going to lose.
Have you ever looked at what differentiates successful traders?
Some traders have special skills that help them see the picture right along with fast computers that help them process information faster. Institutional fund managers get to speak personally to company management, so some may have inside information that crosses the legal line. John Paulson, who made a ton of money betting correctly on mortgages, seems to have bet incorrectly on gold. He knew the mortgages market; he investigated deeply and so on, but it has not worked as well in gold.
So, in my mind, the way traders make a lot of money is not by the alpha [excess return over the benchmark, which is credited to the fund manager], it is really by exploiting the naïve traders who think they can make money. Goldman Sachs makes money trading, not because they make good bets, but because they buy bonds from one pension fund for 10 and sell it to another pension fund for 13. While individual traders play with their own money, pension funds play with investors’ money. The fund managers there enjoy trading. To them investing in index funds and leaving it alone is boring.
That is not a life they envisage for themselves and Goldman Sachs, because it serves them well, says, ‘Good, we will help you trade.’ The investment industry is really a machine that takes money from naïve, mostly individual investors and turns it over to professionals. It is done because you are charged 1%, 2% expense ratio. So what is it that I do? I want more money like everybody else. So I invest exclusively in the lowest cost index funds. I cannot avoid all costs, but I pay 10 basis points, not 1.5%.
Has logic always triumphed emotion in all your personal investment decisions?
Well… not entirely. We just bought a house for our daughter where the original ask was $500,000. Since the housing market is depressed and we were going to pay cash, we made an opening offer of $425,000. The owners came back with an offer of $490,000 and we then upped our bid to $450,000. Then we got an email saying, ‘Sorry, some other people had also bid and it has been sold for full price.’ We were heartbroken as we really liked that house. So we looked for another house, but my wife watched the first house and it turned out that sale fell through. The house was on the market again and we ended up paying $500,000. So I paid $10,000 more than I would have otherwise. But I said to myself, ‘That’s life, your decisions were within reason, you have a good outcome. So don’t beat yourself too much.’
If you are not Goldman Sachs, how do you improve your ratio of smart: stupid decisions in the market?
Framing the situation wrongly is a common error. For example, people are right when they say something like, ‘If I study medicine and perform a lot of surgery, then I will be a better surgeon.’ But when they say, ‘I will study the market, trade a lot, then I will be a better trader,’ — no, you won’t, because the analogy doesn’t work. The beauty of the mind is its ability to jump to conclusions guided by intuition; no computer has intuition. But that is really where the fault of the human brain lies: we are not scientists by nature. So it makes sense to say — that is an interesting idea, but now let me look for evidence that can refute it.
Say you have researched a stock and have concluded that the stock should be double what it is trading at. Then the voice of science or scepticism comes and says, ‘Wait a minute, if it is worth twice the current price, why is the smart money not buying it like crazy? Maybe I missed something. Maybe there are insiders who know the company’s accounting is a sham.’ What I am saying is, we need to be able to step away from ourselves. We need an auxiliary brain that keeps reminding us that sometimes it is not only our eyes but also our intuition that can mislead us. The first line of defence is to recognise that you are subject to error.
Behavioural finance has got the diagnosis right — what is it that we are doing wrong — but when it comes to prescription, how much success are we seeing?
We cannot extinguish stupidity. You can either despair at people’s stupidity or say that stupidity is always going to be with us and we are going to chip at it over time. Maybe people will learn that trying to beat the market is a folly. You may say, ‘Meir, you are way too optimistic,’ and I would say, ‘Probably.’ I use this analogy quite often — when you go to the movie theatre, you know you are going to watch fiction. You go there, the lights turn down, you see the fiction and then they turn the lights back on again. And then you walk outside and are back to reality. The investment business is exactly like that, except they never turn on the lights.