WHAT INVESTORS REALLY WANT

Discover What Drives Investor Behavior and Make Smarter Financial Decisions

By MEIR STATMAN

The McGraw-Hill Companies, Inc.

Copyright ©2011 Meir Statman
All rights reserved.
ISBN: 978-0-07-174165-1

Contents

INTRODUCTION: What We WantCHAPTER 1: We Want Profits Higher than RisksCHAPTER 2: We Have Thoughts, Some ErroneousCHAPTER 3: We Have Emotions, Some MisleadingCHAPTER 4: We Want to Play, and WinCHAPTER 5: We Join Herds and Inflate BubblesCHAPTER 6: We Want Self-Control and Mental AccountsCHAPTER 7: We Want to Save for Tomorrow and Spend It TodayCHAPTER 8: We Want Hope for Riches and Freedom from the Fear of PovertyCHAPTER 9: We Have Similar Wants and Different OnesCHAPTER 10: We Want to Face No LossesCHAPTER 11: We Want to Pay No TaxesCHAPTER 12: We Want High Status and Proper RespectCHAPTER 13: We Want to Stay True to Our ValuesCHAPTER 14: We Want FairnessCHAPTER 15: We Want to Invest in Our Children and FamiliesCHAPTER 16: We Want Education, Advice, and ProtectionCONCLUSION: What We HaveNOTESINDEX

Excerpt

CHAPTER 1

We Want Profits Higher than Risks

In late 2008, Bernard Madoff confessed that his investment company was nothingbut a Ponzi scheme, where longtime investors were paid from the money depositedby new investors. Madoff was sentenced to 150 years in prison, but his investorswere calling on God to punish him some more. “May God spare you no mercy,” criedTom FitzMaurice, a sixty-three-year-old defrauded Madoff investor. “I amfinancially ruined and will worry every day how I will take care of my wife.”Madoff himself “was God,” said Elie Wiesel, the Nobel Peace Prize winner.Wiesel’s foundation lost more than $15 million in Madoff’s fraud, and he and hiswife lost their personal fortune.

Madoff’s investors were not unreasonable, surely not in their own eyes. Theaccount statements mailed to George Rautenberg, one of Madoff’s longtimeinvestors, showed annual profits no higher than 14 percent. “They weren’toutrageous compared with what Harvard was telling you they were doing and whatall those other smart guys were doing,” said Rautenberg. “He wasn’t winning bigat all in the good years. He stayed fairly stable.”

Madoff’s reported returns might not qualify as outrageous, but “winning” and”stable” do not reasonably go together, surely not for individual investors suchas Rautenberg. We can invest in stocks, reasonably expecting high returns withhigh risk, or we can invest in bonds, reasonably expecting low returns with lowrisk. But Rautenberg wanted investments with returns higher than theirrisks—attractive combinations we all want but cannot reasonably expect.Madoff’s reported returns exceeded the returns of stocks in all but two of theseven years from 2001 through 2007, they exceeded the returns of long-term bondsfor all but one year, and they exceeded the returns of short-term bonds each andevery year. Harvard Endowment had higher returns than those reported by Madoffin five of the seven years, but it lost money in 2001 and 2002, two very badstock market years, while Madoff reported gains. Ponzi schemes like Madoff’s arealways fueled by the desire for investments with returns higher than theirrisks.

INDEX INVESTORS AND BEAT-THE-MARKET INVESTORS

The utilitarian benefits of investments center on high returns and low risk.Some investors are index investors, satisfied when they find investments withreturns equal to their risks. Other investors are beat-the-market investors,searching for investments with returns higher than their risks. Beat-the-marketinvestors among us do not expect something for nothing. They are willing to workhard to find investments with returns higher than their risks. They spendweekends analyzing financial statements of companies, distinguishing leadingcompanies from laggards. They spend hours examining charts of the ups and downsof stock prices. They ask friends for names of winning money managers. They readfinancial magazines recommending mutual funds and watch television programsrecommending stocks, bonds, gold, and oil. But cognitive errors and emotionsmislead many beat-the-market investors into the belief that investments withreturns higher than their risks are readily available when, in truth, they arenot.

Think of stocks as ingredients of a stew, some with fat returns and some withlean. Now think of the stock market as a giant well-mixed vat of stew thatcontains all stocks. Some investors dip their ladles into the stew and fill themwith fat and lean in proportions equal to the proportions in the market vat.These are index investors who buy index funds that contain all stocks. Indexinvestors pay the expenses of their funds, but they can easily find index fundswhose expenses are very low, equivalent to a few teaspoons of stew taken out oftheir ladles. Index investors tend to be buy-and-hold investors who trade onlyinfrequently, as when they invest savings from their paychecks into index fundsduring their working years and withdraw them in retirement. While indexinvestors are satisfied with returns equal to risks, beat-the-market investorssearch for returns higher than risks. Some beat-the-market investors choosehandfuls of stocks and trade them frequently, hoping to fill their ladles withmore fat returns than in the ladles of index investors. Others buy beat-the-market mutual funds, exchange traded funds, or hedge funds, hoping that theirmanagers would find stocks with fat returns. But not all beat-the-marketinvestors can be above average. The ladles of index investors are filled withaverage amounts of fat returns. If some beat-the-market investors fill theirladles with above-average fat returns, other beat-the-market investors are leftwith below-average fat returns in their ladles. Moreover, the expenses of beat-the-market investors are higher than those of index investors because beat-the-market investors pay higher costs of trading and the higher costs of beat-the-market managers. Beat-the-market costs are substantial. By one estimate, theannual cost of mutual funds is $100 billion. Hedge funds add $45 billion, andbrokers add more billions.

Yesterday’s Pursuit of Profits Higher than Risks

Beat-the-market investors have always been searching for investments withreturns higher than risks. The World’s Work, a magazine published acentury ago, warned investors away from the belief that they can easily findsuch investments. “Why should I invest money at 4½ percent when I can get 6percent with the same security?” asked a reader in 1911. Because the six percentbond is likely to be riskier than the 4½ percent bond, answered theWorld’s Work.

A New York bonds broker wrote to the World’s Work in 1910 to say that hewas unable to sell the bonds of a city in upstate New York because bonds sold byPhiladelphia brokers offered higher returns. The story was simple, wrote theWorld’s Work. The New York broker was selling bonds on a rail line. ThePhiladelphia brokers, however, were selling bonds on an airline that was toconnect New York and Philadelphia. The World’s Work followed the bonds’story to its conclusion. Three years later, the bonds offered by the New Yorkbroker earned a profit, while the Philadelphia bonds were worthless. ThePhiladelphia property was sold at a bankruptcy sale for a price that leftnothing for its bondholders.

Stocks were less common in the portfolios of individual investors a century agothan in today’s portfolios, and they were considered more risky than they areconsidered today. The World’s Work did not seek to discourage investmentin stocks whose returns equaled their risks but added that “it is unalterablyopposed to the investment of savings by inexperienced people in new, untried,poorly-backed or wildly-financed enterprises.”

Mining enterprises constituted a large proportion of poorly-backed and wildly-financed enterprises a century ago and the failure of one precipitated the Panicof 1907. The World’s Work was beset by inquiries from investors askingfor advice on mining stocks and its advice was unequivocal. “To one and all, thereply has been that the small investor should by no means purchase miningstocks. We shall make no exception to this statement…. The old adage that aWestern mine is ‘a hole in the ground with a liar at the top’ holds good in aremarkably large proportion of cases. Emotion plays too large a part in thebusiness of mining stocks. Enthusiasm, lust for gain, gullibility are the realbases of this trading. The sober common-sense of the intelligent business manhas no part in such investment.” The World’s Work punctuated its warningwith a story about a man, the son of a country doctor, who reached adulthood andwas about to go into business. His father took him into the little back office,swung open the door of the rusty old safe, and took out a thick bundle of stockcertificates. “My son,” he said, “you are going into business, and, I hope, willmake some money…. When the time comes you will wish to buy some mining stock.Everyone does. When that time arrives come to see me. I will sell you some ofmine. They are just as good, and will keep the money in the family.'”

Today’s Pursuits of Profits Higher than Risks

Lessons from a century ago need repeating because we fail to learn. Almost halfa million Italian retirees bought Argentine bonds in the 1990s because theyoffered higher interest rates than Italian bonds. The word defaultbecame an Italian word in 2001 when Argentina defaulted on its bonds. In 2005Nestor Kirchner, Argentina’s president at the time, offered to pay bondholdersless than a third of their investment. When Rodrigo de Rato of the InternationalMonetary Fund called on Argentina to be respectful to bondholders, Kirchnermocked him, “It’s pathetic to listen to them sometimes.” “Enter now,” saidKirchner to the bondholders, “or it will be your problem.” In 2010 CristinaFernández de Kirchner, who succeeded her husband as Argentina’s president,offered bondholders a deal no better than the one offered by her husband fiveyears before. “At this point they could accept anything,” said Lucio Golino, whoworks with a consumer protection group in Rome. “A lot of people are tired andhave had enough.” But Egidio Rolich, who bought Argentine bonds with theproceeds from the sale of an apartment and his wife’s severance pay, was notready to accept Argentina’s offer. “Investors were shafted the first time withthe default,” he said, “the second time with the 2005 swap and this time isgoing to be the third.”

The desire for returns higher than risks also fuels the Nigerian 419 scams weknow from e-mails of the kind I received from Mrs. Catharina Kitty Sies from theNetherlands, addressed to “Dearly beloved in Christ.” Mrs. Sies was married tothe late James Davis “of blessed memory” who worked with the South AfricanEmbassy before he died. While at the embassy, Mr. Davis deposited $25 millionwith a company in Europe. Now Mrs. Sies is ill with cancer and fibroid problemsand her doctor told her that she has no more than three months to live. “Havingknown my condition,” wrote Mrs. Sies, “I decided to donate this find to either acharity organization, devoted Christian individual, or God-fearing person whowill utilize this money the way I am going to give instruction with allsincerity to fund churches, orphanages homes, widows and also propagating theword of God.” Mrs. Sies promised to send me the $25 million “luggage” as soon asshe receives my reply.

Nigerian 419 scams seem easy to detect yet prove irresistible to those lookingfor returns higher than risks. The United States Secret Service estimates thatsuch scams cost Americans more than $100 million each year. Yet Americans arenot alone as scam targets. Australians make good targets as well according to areport by the Australian Securities Investments Commission (ASIC). Australiansare targeted, wrote ASIC, because their interest in investments is not matchedby knowledge. Men are by far more gullible than women, accounting for more thannine out of ten scam victims.

Banks sold $7 billion of reverse convertibles in 2008, promising returns higherthan risks and collecting fees in the process. Reverse convertibles are bondslinked to stocks such as Apple and Johnson & Johnson. Investors were promisedhigh interest rates during the life of the bonds in addition to their investedmoney when the bonds mature. Yet if the prices of the stocks to which the bondsare linked fall, investors get the stocks rather than their invested money. Thehigh interest rates of reverse convertibles were enticing, but not all investorswere aware of their risks. Lawrence Batlan, an 85-year-old retired radiologist,invested $400,000 in reverse convertibles linked to stocks such as Yahoo! andSanDisk. He lost $75,000 of it when stock prices declined. “I had no idea thiscould happen,” said Dr. Batlan. “I have no desire to own Yahoo! stock or theothers.”

The “accumulator” was also an investment that was too good to be true, but thisone was offered mainly to investors in Hong Kong. Accumulators obliged investorsto buy shares of a stock at a fixed price. Investors profited if the price ofthe shares increased but lost if the price decreased. Yet the profit potentialof investors was limited by a condition mandating that they sell their sharesback to the issuer if their price increases to a specified level. The year 2008was bad for investors in accumulators as stock prices declined and investorsnicknamed accumulators “I kill you later.” The fundamental flaw … is somethingthat I learned from my grandmother,” said Kathryn Matthews, an investmentprofessional. “You get nothing for free.”

The trading records of thousands of investors at an American broker reveal thatthe returns of the heaviest trading beat-the-market investors trailed those ofindex investors by more than seven percentage points each year on average, whilethe lightest trading investors trailed by only one-quarter of a percentagepoint. The trading records of thousands of investors at a Swedish broker revealthat, on average, the losses of heavy traders amounted to almost 4 percent oftheir total financial wealth each year.

Beat-the-market investors trail further behind index investors because they tendto buy high and sell low, reversing the investment maxim of buying low andselling high. Investors who switched stocks frequently in 19 major internationalstock markets trailed index investors by an average 1.5 percentage points eachyear. Investors who switched mutual funds frequently trailed buy-and-hold mutualfund investors by less than one percentage point if they switched among mutualfunds dedicated to stocks of large-value companies, but the lag increased tomore than three percentage points if they switched among mutual funds dedicatedto stocks of small-growth companies, and to an astonishing 13 percentage pointsif they switched among mutual funds dedicated to stocks of technology companies.Switching-hedge-fund investors did no better than switching mutual-fundinvestors. Hedge fund investors who switched among funds trailed those whobought and held hedge funds by approximately four percentage points each year.Those who switched among “star” funds with the highest returns trailed byapproximately nine percentage points.

BEAT-THE-MARKET INVESTORS EXPLAINED

Why don’t beat-the-market investors abandon their game and join index investors?One part of the answer is easy. While average beat-the-market investors cannotbeat the market, some beat-the-market investors are above average. Professionalinvestors, such as mutual fund and hedge fund managers, regularly beat themarket. Stocks bought by beat-the-market mutual fund managers had higher returnsthan stocks sold by them. And hedge fund managers are famous for thebillion-dollar paychecks they earn by beating the market. But investors inbeat-the-market mutual funds trail investors in index funds because the costs ofbeat-the-market mutual funds detract from the returns passed on to investorsmore than managers add to them. Hedge funds are riskier than investors believeand the returns they pass on to investors are lower than investors believe. TomPerkins, a wealthy venture capitalist, tells about Harry, one of his investors,who asked him how Perkins can live with the risk of his investments. “Well,Harry,” laughed Perkins, “it’s your money!”

Military service is mandatory in Finland so that nearly every Finnish male ofdraft age undergoes extensive intelligence tests. Intelligence promotesinvestment success. Finns who score highly on intelligence at draft age arebetter at picking stocks in the following years than their less intelligentbrethren. Germans who score highly on cognitive skills resist cognitive errorsbetter than their less intelligent brethren. Highly intelligent investors mightbe able to beat the market, but their success is far from assured becauseintelligent investors are not always wise. Harvard staff members are intelligentand so are Harvard undergraduate students with SAT scores in the 99th percentileand Wharton MBA students with SAT scores at the 98th percentile. Staff andstudents received information about past performance and fees of index fundsthat track the S&P 500 Index. But the information about the funds varied by thedates when the funds were established and the dates when the funds’ prospectuseswere published.

Wise investors faced with a choice among index funds following the S&P 500 Indexchoose the index fund with the lowest fees since these index funds are otherwiseas identical as identical cereal boxes. But nine out of ten staff and collegestudents chose index funds with higher fees and so did eight out of ten MBAstudents. Staff and students chased returns instead, choosing funds with thehighest historical returns, apparently assuming that these offer returns higherthan risks. Staff ranked fees as the fifth most important factor in their choiceof funds, out of eleven factors, and students ranked it eighth. Staff chosefunds whose annual fees exceeded the minimum fee by more than two percentagepoints on average, and students chose funds whose fees exceeded the minimum feeby more than one percentage point.

Insiders Deepen the Beat-the-Market Puzzle

Some investors have access to inside information, such as information aboutmergers being negotiated or disappointing earnings about to be revealed.Investors with inside information include corporate executives and investorswith links to executives, including investment bankers and hedge fund managers.Members of Congress have inside information as well. Only one-third of Americansenators bought or sold stocks in any one year during the boom years of the1990s but trading senators did very well. While corporate insiders beat themarket by six percentage points each year on average, trading senators beat itby 12 percentage points. “I don’t think you need much of an imagination torealize that they’re in the know,” said Alan Ziobrowski, one of the authors ofthe study.

Insiders can beat the market without crossing the legal line, but sometimes theycross it. Some are comical in their incompetence. Bonnie Jean Hoxie, a WaltDisney administrative assistant, and Yonni Sebbag, her boyfriend, offered insideinformation about Disney’s earnings in a letter to almost two dozen hedge funds.The letter said: “Hi, I have access to Disney (DIS) quarterly earnings reportbefore its release on 5/03/10. I am willing to share this information for a feethat we can determine later…. My e-mail is XXX. I count on your discretion asyou can count on mine.” One of the hedge funds was not discrete, notifying theauthorities. FBI agents pretended to be representatives of a hedge fund and paidSebbag $15,000 for the information before arresting him and his confederate.

(Continues…)
(Continues…)Excerpted from WHAT INVESTORS REALLY WANT by MEIR STATMAN. Copyright © 2011 by Meir Statman. Excerpted by permission of The McGraw-Hill Companies, Inc..
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.