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Behavioral Finance : the Second Generation (2019) MONOGRAPH BEHAVIORAL FINANCE / CFA INSTITUTE RESEARCH FOUNDATION / MONOGRAPH BEHAVIORAL FINANCE The Second Generation MEIR STATMAN STATMAN BEHAVIORAL FINANCE The Second Generation Meir Statman Statement of Purpose The CFA Institute Research Foundation is a not- for-profit organization established to promote the development and dissemination of relevant research for investment practitioners worldwide. Neither CFA Institute Research Foundation, CFA Institute, nor the publication’s editorial staff is responsible for facts and opinions presented in this publication. This publication reflects the views of the author(s) and does not represent the official views of CFA Institute Research Foundation. CFA®, Chartered Financial Analyst®, and GIPS® are just a few of the trademarks owned by CFA Institute. To view a list of CFA Institute trademarks and the Guide for the Use of CFA Institute Marks, please visit our website at www.cfainstitute.org. © 2019 CFA Institute Research Foundation. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the copyright holder. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. Cover photo credit: DigiPub / Moment / Getty Images ISBN 978-1-944960-85-8 Biography Meir Statman is the Glenn Klimek Professor of Finance at Santa Clara University. His research focuses on behavioral finance. He attempts to under- stand how investors and managers make financial decisions and how these decisions are reflected in financial markets. His most recent book isFinance for Normal People: How Investors and Markets Behave, which was published by Oxford University Press and rated as an Outstanding Business Reference Source by the American Library Association. The questions he addresses in his research include the following: What are investors’ wants, and how can we help investors balance them? What are investors’ cognitive and emotional shortcuts and how can we help them over- come cognitive and emotional errors? How are wants, shortcuts, and errors reflected in choices of saving, spending, and portfolio construction? How are they reflected in asset pricing and market efficiency? Professor Statman’s research has been published in the Journal of Finance, the Journal of Financial Economics, the Review of Financial Studies, the Journal of Financial and Quantitative Analysis, the Financial Analysts Journal, and the Journal of Portfolio Management, among many other journals. The research has been supported by the National Science Foundation, CFA Institute Research Foundation, and the Investment Management Consultants Association. Professor Statman is a member of the advisory board of the Journal of Portfolio Management, the Journal of Wealth Management, the Journal of Retirement, the Journal of Investment Consulting, and the Journal of Behavioral and Experimental Finance; an associate editor for the Journal of Behavioral Finance and the Journal of Investment Management; and a recipi- ent of a Batterymarch Fellowship, a William F. Sharpe Best Paper Award, two Bernstein Fabozzi/Jacobs Levy Awards, a Davis Ethics Award, a Moskowitz Prize for best paper on socially responsible investing, a Matthew R. McArthur Industry Pioneer Award, three Baker IMCA Journal Awards, and three Graham and Dodd Awards. Professor Statman was named one of the 25 most influential people byInvestment Advisor. He consults with many investment companies and presents his work to academics and professionals in many forums in the United States and abroad. Professor Statman received his PhD from Columbia University and his BA and MBA from the Hebrew University of Jerusalem. © 2019 CFA Institute Research Foundation. All rights reserved. iii Contents Foreword: Managers, Examine Thyselves ............................................... vii Introduction ........................................................................................... ix 1. Normal Investors ................................................................................. 1 2. What Investors Really Want ................................................................ 8 3. Cognitive Shortcuts and Errors ........................................................... 25 4. Emotional Shortcuts and Errors .......................................................... 47 5. Balancing Wants, Acquiring Knowledge, and Correcting Errors ......... 66 6. Behavioral Portfolios ........................................................................... 81 7. Behavioral Life Cycle of Saving and Spending .................................... 106 8. Behavioral Asset Pricing...................................................................... 122 9. Behavioral Efficient Markets ................................................................ 141 Conclusion .............................................................................................. 165 Epilogue: My Way to the Second Generation of Behavioral Finance ...... 170 References .............................................................................................. 180 Index....................................................................................................... 209 This publication qualifies for 5 CE credits under the guidelines of the CFA Institute Continuing Education Program. © 2019 CFA Institute Research Foundation. All rights reserved. v Foreword: Managers, Examine Thyselves Too frequently, investors—amateurs and professionals alike—unknowingly fall prey to their best investing intentions. Most often, their disappointment stems from a wide array of well-documented behavioral influences. We know that they are harmful to our financial health, yet we persist in them. Why are behavioral dilemmas so sticky to overcome? Read on: In my mind, Meir Statman, the distinguished author of the CFA Institute Research Foundation monograph we present here, is an academic detective. He has been fascinated by behavioral finance for many, many years. I met him as young, wide-eyed academic, full of vigor. He has not changed: He is as feisty as ever. I am allured by his academic insights, especially because they are implementable. This book is pure Meir—energetic, practical, understand- able, and implementable. Meir’s research books and papers all provide invaluable insights on investment decision making for amateurs and professionals alike. As such, I have been hooked on his insights for many years. Other academics may be equally brilliant, but frankly, I have trouble understanding all those compli- cated descriptions and formulas. Meir, however, has not lost his touch for making complicated material understandable. He writes books with titles like Finance for Normal People and What Investors Really Want. My long fasci- nation for the knowledge and insights that behavioral finance offers to money managers has been highly influenced by his research. Behavioral finance has blossomed—and justly so. It is a key to the justi- fication for active portfolio management. If investors were perfectly rational and always acted in their enlightened self-interest, active management would still have a role because different investors have different goals and preferences and may require different portfolios. Roger Ibbotson, with three colleagues, demonstrated in Popularity: A Bridge between Classical and Behavioral Finance that an investment may be popular (and thus offer inferior prospec- tive returns) for perfectly rational reasons—for example, because it offers liquidity or tax savings. And it may be unpopular (and thus offer superior prospective returns) for precisely opposite reasons. But active management based on investor irrationality—that is, on behavioral finance—is much more interesting and likely to be much more rewarding. It turns us into detectives like Meir, hunting down parts of the market where euphoria, despair, ignorance, greed, fear, and a litany of other © 2019 CFA Institute Research Foundation. All rights reserved. vii Behavioral Finance behavioral faults reign and prices depart from their fair value. It is in these situations where active managers can add the most value. I believe that, while some managers have gotten pretty good at combing the market for these opportunities, they have been less skillful at examining themselves for potential cognitive flaws. Meir Statman’s book shines a bright light not only on the imperfections of markets but also on the areas where self-evaluation by managers will provide ideas for improvement. For these and many other reasons, the CFA Institute Research Foundation is excep- tionally pleased to present Meir Statman’s latest work, Behavioral Finance: The Second Generation. Arnold S. Wood Founder and Retired CIO, Martingale Asset Management Former Chair, CFA Institute Research Foundation Board of Trustees October 2019 viii © 2019 CFA Institute Research Foundation. All rights reserved. Introduction A driver told me his story recently, on our way to the Santiago, Chile, airport. He was a representative of a Swiss pharmaceutical company in California in 2006, on a contract set to expire in 2008. His friends were
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