Understanding Behavioral Finance

#526: Recorded LIVE on stage at the Morningstar Conference in Chicago! We chat with behavioral finance professor Meir Statman. He breaks down the differences between standard finance and behavioral finance, making it clear that understanding human behavior is an essential part of investing.

Statman starts by explaining that standard finance assumes people are rational. They make decisions purely based on logic and aim to maximize wealth. However, behavioral finance sees people as normal, not always rational. We often act on emotions and cognitive shortcuts. For instance, people might prefer receiving dividends over selling shares, even if both result in the same financial gain. This is because dividends feel like income, while selling shares feels like dipping into savings.

He uses a great metaphor to explain how investors view their portfolios. Think of a dinner plate: behavioral investors like their investments separated, like mashed potatoes on one side, vegetables on another, and steak in the middle. Rational investors don’t care if it’s all blended together because they only focus on the total nutrients. This shows that normal investors have different needs and want to balance safety with growth.

Statman talks about the importance of diversification. He recalls a lunch with Harry Markowitz, the father of Modern Portfolio Theory, who supported the idea of having a mix of safe and risky investments. Markowitz himself had municipal bonds to avoid poverty and stocks to grow wealth. Diversifying helps investors manage risk and meet both their safety and growth needs.

We then dive into how people manage money across their life cycle. Statman points out that young people know they need to save but are tempted to spend. They often control this urge by putting money into retirement accounts like 401(k)s. As people get older, they become so good at saving that they sometimes forget to spend and enjoy their money. Statman gives a funny example of his mother-in-law, who refused to replace an old sofa because she didn’t want to dip into her savings.

Statman also touches on asset pricing and market efficiency. He explains that while traditional finance focuses solely on risk, behavioral finance considers other factors like social responsibility. Some investors are willing to accept lower returns to stay true to their values. Additionally, he argues that market prices do not always reflect true value, and it’s hard to predict when they will.

Towards the end, we discuss the broader aspects of wellbeing. Statman emphasizes that financial wellbeing is just one part of a happy life. Family, health, work, and community are also crucial. He believes financial advisors should help clients achieve overall life wellbeing, not just financial success.

For more information, visit the show notes at https://affordanything.com/episode526

Timestamps

Note: Timestamps vary on individual listening devices based on advertising run times.

1:23 - Explain the differences between standard and behavioral finance.

4:30 - Discuss Harry Markowitz's influence on modern investment strategies.

6:08 - Highlight life cycle investing and saving/spending behaviors over a lifetime.

10:02 - Explore mental accounting and differentiating between income and capital.

11:14 - Talk about common trading mistakes due to cognitive errors.

14:26 - Discuss utilitarian, expressive, and emotional benefits of financial decisions.

17:41 - Explain the difference between System 1 and System 2 thinking.

21:39 - Discuss how emotions and moods impact investment decisions.

25:59 - Explore the concept of regret and how it affects financial decisions.

30:21 - Emphasize the importance of human touch in financial advising.

44:00 - Discuss the impact of AI on different industries and investment decisions.

48:24 - Highlight the need to balance financial wellbeing with overall life wellbeing.

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