FREE NEWSLETTER

Not So Dumb

Jonathan Clements  |  May 20, 2017

IT’S ONE OF WALL Street’s more galling rituals: its regular dismissal of everyday investors as stupid. They’re the “dumb money” you should watch so you know what not to buy—the sheep that the “smart money” regularly fleeces.

This narrative was bolstered by early behavioral finance research, which detailed our many mental mistakes: In our overconfidence, we trade too much and make large investment bets. We’re overly influenced by recent returns. We assume our investments perform better than they really do. We hang onto losing investments, because we hate selling at a loss and admitting we made a mistake. We discount the future at too high a rate. We latch onto evidence that confirms our beliefs, while ignoring information that might force us to revise our position.

The archetype of the dumb small investor was always a little suspect—and it’s become ever harder to sustain, as evidence mounts that professional investors also regularly underperform the market averages and also make their own fair share of behavioral mistakes.

Moreover, this focus on smart and dumb money ignores an alternative explanation: Even if investors aren’t rational as judged by classical economics, their behavior can make sense if we consider what they’re aiming to achieve with their money.

That’s the intriguing argument advanced by finance professor Meir Statman in his fascinating new book, Finance for Normal People. His book represents what he calls “second generation” behavioral finance. In the first generation, it was all about identifying behavioral oddities and dismissing them as mistakes. In the second generation, those mistakes are being reappraised—and viewed as more sensible when we consider investors’ wants.

As Statman explains, our purchases—including the investments we purchase—offer three benefits: utilitarian (what it does for me), expressive (what it says about me) and emotional (how it makes me feel). Hedge fund performance has been disappointing—the utilitarian benefits are often far less than promised—and yet folks are still anxious to buy, because owning a hedge fund makes them feel special and gives them bragging rights at the country club. They get mediocre returns, but maybe they’re still getting their money’s worth.

That doesn’t mean we never make errors. Investors—professional and amateur—are subject to a host of cognitive and emotional mistakes. Those mistakes can occur when we make decisions based on intuition alone, when it would have been wiser to hit the pause button and call on the reflective, slower-moving part of our brain.

For instance, rapidly trading stocks is unlikely to deliver market-beating returns, but folks find it thrilling and it gives them the occasional winner that they can boast about. So is this a sensible way to address our wants? Obviously not, if we’re betting our entire portfolio on the foolish assumption that we can predict market movements and outsmart other investors. We’re likely falling victim to a host of cognitive and emotional errors. But if we create a “fun money” account with a sliver of our savings, knowing we’ll have lots of fun but probably not much financial success, then it seems more sensible.

In its early days, classical economics would dismiss behavioral finance as just a collection of “interesting stories.” But today, behavioral finance is much more than that. Statman takes the notion of wants, coupled with potential errors, and offers up theories of how portfolios are constructed, how stocks are priced, why markets can’t be beaten and how folks think about spending and saving over their lifetime. The theories may need fine-tuning—but they seem right, because they take fuller account of the messy way humans behave.

Finance for Normal People is geared toward an academic audience, but it has much to offer everyday investors. Statman has an engaging writing style, mixing theory with real-life examples. My advice: Put the book on your bedside table and occasionally dip into one of the chapters. It’ll help you figure out what wants you have—and help you avoid costly cognitive and emotional errors.

Free Newsletter

SHARE