What do you want from your investments?

I recently had the opportunity to interview Meir Statman, author of the new book What Investors Really Want, and a professor of finance at Santa Clara University in California. Professor Statman is one of the world’s leading experts in behavioural finance, and his new book explores the ways that our emotions and desires affect the way we invest.

In a series of posts this week and next, I’d like to take a detailed look at some of the ideas that Prof. Statman and I discussed. At the end of the series, I’ll announce a contest where readers can win a copy of What Investors Really Want to add to their own financial library.

Let’s open with one of the main ideas that Statman introduces in the book. Why do we invest? The answer may seem obvious: to build a retirement nest egg, or a college fund for our kids, or for some other specific financial goal. But our desires go beyond these utilitarian benefits. Statman explains that we also get expressive and emotional benefits from investing. For example, active investors savour the thrill of trying to beat the market, while hedge fund investors enjoy the status of membership in a fund that’s closed to all but the most wealthy.

Honk if you drive a Honda

I began our conversation by asking Prof. Statman how this applies to index investors, who clearly don’t enjoy any market-beating thrills or exalted status when they focus low-cost index funds:

“What I want from my investments is mostly the utilitarian benefits that I speak about, and I want expressive and emotional benefits from other areas of my life. As an index investor, I economize in the area of investments, but I don’t mind, for example, buying an expensive painting that may cost thousands of dollars, when in fact a $20 poster is going to cover more of the wall.

“But, in fact, I am deriving expressive and emotional pleasures from index funds as well. Let me explain: there are people who take pride in having a $10,000 watch, and there are other people who actually take pride in having a $10 watch, because they consider people who buy $10,000 watches to be idiots and show-offs. They know that a $10,000 watch shows the same time as a $10 watch. So there is kind of a pride in being smart, and in being frugal— not cheap, but just plain frugal.

“I liken index investing to buying a Honda Accord. A Honda Accord is a car that gives you a high Sharpe ratio—a high ratio of returns to risk. If you can live with that, that is fine. But understand that some people want to have the Acura—which is a dressed-up Honda—because they also want the prestige that comes with luxury buying. This might be because they are in the company of people who always brag about their possessions, and they feel that they are going to be regarded as low-class if they drive a Honda. So it’s important for us to know what is people want.

“I should note that while I belong to the index fund crowd, I am not religious about it. I don’t regard people who belong to another persuasion, or another religion, as destined not to go to heaven. I happen to have have a $100 watch, and somebody might say I’m wasting my money, because a $10 watch shows the same time. But I like it—it’s beautiful in my eyes, and it’s worth it to me.

“So what I am saying is give people some space—cut them some slack. Some people like the hope that comes with active funds. Some people like to be socially responsible, and perhaps they find it hard to do that with the available index funds. People want different things, and the fact that they choose differently does not necessarily mean they are ignorant or stupid. They might just have different tastes than you have. I find that in both camps there is an increasing level of shrillness, where it is ‘my way or the highway.’ But I say we’ll all end up in heaven.”

Can’t we all just get along?

I liked Prof. Statman’s message of tolerance, and confessed that I’ve probably added to the shrillness by coming down hard on investor success stories and media reports about market-beating mutual funds. Here’s how Prof. Statman responded:

“Let me just add that the index group is right in saying that outperformance might just be a fluke: this is another distinction I make in the book. There is a distinction between what is a preference and what is an error. To the extent that people in the active group say, ‘Don’t tell me that I cannot beat the market, because such-and-such a fund beat the market,’ I think somebody has to point out the usual analogy of coin tossing, and that you are always going to have winners. I think index investors are right in pointing out the errors that many active investors make. But at the same time, they should not press their case too far and say that people should focus only on the utilitarian benefits of investing, and that anyone who diverges from that is an idiot. Maybe they’re not: maybe they just have different tastes.”