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I recently sat down with Meir Statman, a professor of finance at Santa Clara University and the author of the book What Investors Really Want. Meir is an expert on behavioral finance and socially responsible investing.
James Early: A big premise of your book is that whether we are buying an iPad, a fleece pullover from Patagonia made from recycled soda bottles, or a Prius -- and I bought all three recently -- we are not just buying the product; we are buying into a lifestyle. We are buying into an image. You basically say that we do that with investments, too. Can you elaborate?
Meir Statman: Yes. When you ask investors why they invest, the answer is always, of course, to make money. But if you explore it a bit, you see that it is much more than that. It is much more like an iPad in that stocks and other investments have utilitarian benefits. Making money is one, but there are also expressive and emotional benefits in messages that you send when you have an iPad: that you are part of a club, that you are forward-looking, and so on.
An obvious investment example is socially responsible investing, where people care about making money, of course, from socially responsible funds, but they also want to have the feeling that we have when we drive a Prius -- that we are taking care of the environment.
Or another one that might be related to the audience of The Motley Fool: the joy of investing, of poring over stocks, of talking with people about it. It really is a hobby, very much like fixing an old car. The difference is that people will tell you that fixing cars is a hobby -- that they do it because they enjoy it -- but when it comes to investing, people are either blind to themselves or lying to others when they say that all they care about is money.
Early: I used to work in the hedge fund industry (as a quick anecdote), and I was amazed that these managers would go to conferences -- and they would have run money for 10 years; at that point, the track record is really what matters -- but their presentation materials had 10 pages on manager background and only one or two pages on returns. And they were still attracting money. In other words, people just seemed so drawn to the image -- to the prestige of investing with particular hedge funds -- over the actual returns. Now maybe that's different these days, but at the time, it was true.
Statman: I doubt that it's different these days. If you think about Bernie Madoff, the way he got people in was not just because he had relatively high and stable returns, but also because of the cachet that he had. He was renowned for first rejecting people who wanted to invest with him, and then, when their friends pleaded with him, he reluctantly admitted them to the club. And it worked very well while it worked.
Early: We're not very smart sometimes, are we?
Statman: Well, it's not that people are not very smart; we are generally smart. It is just that, sometimes, we are stupid. But I think that we have to forgive our stupidity to ourselves. We are only human. And we have to realize that eventually, money is for something, and sometimes that something is the enjoyment of playing with the money itself. It is a matter of keeping things in proportion. Play with your investments if you enjoy playing, but don't put your retirement money into some get-rich-quick scheme that is going to backfire on you.
Early: Let's go back to socially responsible investing, and let's just do a hypothetical. Pretend that I have heard that the Kimberley Process, which governs the diamond trade [aiming to prevent blood diamonds from entering the market], is flawed. So I refuse to invest in Anglo American [(OTC: AAUKY)], which now owns De Beers. But then I learn that industrial companies actually use 75% of all diamonds mined. Is the world too complicated for socially responsible investing?
Statman: In some ways, it is complicated. I mean, people are complicated, and companies are complicated as well. You will not have a perfect person, and you will not have a perfect company, and so it is a question of: What kind of flaws are you willing to accept? For some people, it is not to be involved in blood diamonds. For others, it is about employee relations. How does the company treat its employees? For some, it is matters of religion -- that they are opposed to abortion. And so you have to figure out what matters to you, and if something is sufficiently revolting to you, and you decide not only not to use the product, but also to stay away from the company's stock, good for you.
Early: Meir, your book talks about a lot of different cognitive errors or traps that investors may fall into. In your view, what are some of the very most common or most powerful?
Statman: I think that faulty framing comes first, because investors frame the investment game or the trading game wrong, and they end up losing. When you buy a stock because you are sure that it will go up, you always have to ask yourself: Who is the idiot on the other side of the trade? Because in every trade, there is an idiot, and if you don't know who it is, it is you.
The way to frame a trading game is not like playing tennis against the wall -- where you can place yourself in the right spot to hit the ball back -- it is like playing tennis against Roger Federer on the other side of the net, and when you know that $100,000 is on the line for the winner. Then you hesitate to enter the game. The same should be the case when you are considering buying a stock or buying gold or buying anything else. Trading often is going to defeat you.
Hindsight is another one that is very important. I think that we have this tendency to think that we knew for sure in 2007 that the markets would go down in 2008. If we actually wrote down what we thought in 2007 in ink and went back to read it, we probably said something like, "It looks like stocks are kind of high. It looks like something is funny in housing. I think that we should think about it," and so on. But when 2008 and 2011 come, what we remember is that we knew for sure that stocks will go down, and all the ifs and buts kind of disappear.
Early: It seems like a lot of the focus in behavioral finance is on identifying these cognitive errors or biases and thinking of ways to avoid them. Why doesn't someone start a cognitive errors exploitation fund? Isn't that what successful investing comes down to -- simply exploiting the emotional weaknesses of others?
Statman: Well, there are funds that try to do just that, but if you think about it, the entire finance industry -- not the entire, but big portions of the financial industry -- are really designed to do precisely that. That is, to exploit the cognitive errors of others, except that it is their customers' errors that they exploit. In other words, it is managers of active funds that charge 1.5% or 2% who are really reaping the benefits of cognitive errors of investors who think that by investing with them, they are going to gain more money.
Early: Interesting. Can you broadly discuss how you invest personally?
Statman: I invest in index funds exclusively, but I hasten to add this is not for everybody. That is, I drive an old Toyota, even though I can afford pretty much any car I want, because that is my style; that is my notion of myself. But if you want to buy a Lexus because you want some prestige, if you want to invest in a hedge fund because you want some prestige, go ahead. If you like the zoom of a sports car, go ahead and buy that. Just don't tell me that the sports car that you have is going to get you to work faster. It won't -- but it will make you feel good. And if an active fund and trading makes you feel good, fine. Just don't waste your retirement money on those kinds of gadgets.
Early: That sounds like the truth. Are you optimistic that the current world economy will create above-average buying opportunities?
Statman: Who knows? I don't know, but ask me in a year and I will tell you that I knew for sure. I don't know. I don't know. I really am a diversified investor who has stock funds, domestic, international, bond funds. I have money such that I will not be poor; that's what bonds are for. I have money for a chance to be rich; that is what stocks are for. And I just ride whatever bubble comes up and down. That is, I know from my research -- and that is very important -- that we trust science. I know from my science and other people's science that people who try to time the market mostly end up being losers. So avoiding doing stupid things makes me half smart.
This interview originally appeared in James' Motley Fool Income Investor newsletter. To find out more ways Meir Statman seeks to avoid the common behavioral pitfalls of the average investor, head online and check out his blog at whatinvestorswant.wordpress.com.