Promoting the wealth and well-being of your clients: Managing risk, regret, fear and hope

Promoting the wealth and well-being of your clients: Managing risk, regret, fear and hope

Meir StatmanGlenn Klimek Professor of Finance

Santa Clara Universityhttp://lsb.scu.edu/finance/faculty/Statman/

Default.htm

January 1997

The Story of Sharon and Russ Gornie

Hopes and Fears

Gornies Clip Here

Standard Finance and Behavioral Finance

Standard Finance – Investors are rational.

Behavioral Finance – Investors are normal.

We are neither rational nor irrational

We are normalWe know Sharon and Russ.

We know their hopes.We know their fears.

We know their aspirations.Can we help them?

It is about more than money.It is about more than risk and

returns.It is about: hope

fearwinningstressstatussecurity

It is about: life

What do normal investors want?

Financial PhysiciansPhysicians promote more than

health.

They promote health and well-being.

Financial advisors are financial physicians.

The promote wealth and well-being.

Financial advisors manage investments.

Financial advisors manage investors.

Financial Physicians

Ask, listen, empathizeDiagnoseEducate

Treat

First Lesson to investors and advisors

Know YourselfMake yourself your ally

Know your goals

Know your emotions

Know your cognitive biases

Second Lesson to investors and advisors

Protect YourselfMake science your ally

Know the science of financial markets.

Know the science of human behavior.

Third Lesson to investors Protect Yourself

Make your financial advisor your allyGood financial advisors are like good

physicians. They educate and sometimes they nudge.

Good financial advisors promote both wealth and well-being.

Third Lesson to advisorsBe a good financial physician

Cognitive Biases and Emotions

Rome Airport


Rome Hotel


Rome Hotel


Rome Hotel


Cognitive biases• Framing

– Size and color of Euro bills– Mental accounting (Where do the

€80 belong?)• Hindsight• Emotions

– Embarrassment– Anger– Regret


How can we overcome hindsight?

How can we make peace with losses?

The pain and the phantom pain of regret.

Cognitive biases and emotions

RegretInvestors overcome the pain of

regret by shifting responsibility.

I am not stupid.

My financial advisor is stupid.

Financial advisors are tempted to strike back.

“If we’re being honest, it was your decision to follow my recommendation

that cost you money.”

Cognitive biases and emotionsHindsight and regret

GoogleCikovsky took $4,000 cash.

Patterson took 16,000 stock options.16,000 Google shares

@ $85/share = $1,360,000@ $300/share = $4,800,000@480/share = $7,680,000

Cognitive biases and emotions

Hindsight and regret.

Why didn’t I get my $4,000 in Google options?

Make science your allyCombating cognitive biases and

emotionsEducation (We are all subject to

hindsight bias and regret) Cikovsky: Do I wish I’d had the

shares? Yes…but what’s always in the back of my mind is an IPO is never

guaranteed…and 9 out of 10 start-ups fail”

Wheat Bran Dietary Supplement Appears Not to Reduce Risk for

Developing Pre-Cancerous Colorectal Polyps.

New England Journal of Medicine (2000)

Make science your allyEvidence – Based MedicineTheory, hypotheses, and

empirical evidence

Make science your allyThe science of human

behaviorBut why do we behave as we do?

Because we are intelligentWe search for patternsWe jump to conclusions

We are affected by emotionsWe fall into pitfalls of cognitive

biases

Evolutionary Psychology

Darwinian Psychology

Why is intuition so appealing?

The scientific method as a check on intuition

A brain module for recognizing faces

Recognizing faces clip here

Of Rats and Men.

Who is more intelligent?

Touch a button, S or B

You win (money or food) if the choice is right.

S B

Intelligence - Searching for Patterns

0%

20%

40%

60%

80%

100%

1 2 3 4 5

Men

Rats

Time

Touching Button SB

S 4/5 chance of winning

1/5 chance of winning

Intelligence - Searching for Patterns

Never

4/5Alway

s

Make science your ally

Are the patterns you see really

there?

Portfolios and AssetAllocation

QuestionIf you could increase your chances of

having a more comfortable retirement by taking more risk, would you:

a. Be wiling to take a little more risk with all your money?

b. Be willing to take a lot more risk with some of your money?

If you could increase you chances of improving your returns by taking more risk, would you:

Risk Money

=xA lot more

riskSome of

your moneyAddition to

portfolio risk

=x All of your money

A little more risk

Addition to portfolio risk

a.

b.

Mean-variance portfolio theory

Investors care only about risk andexpected returns.

Investors are averse to risk.

Investors consider portfolios as a whole.

37

Mean-Variance Portfolio Theory

Investors are not always averse to risk

Investors buy both insurance policies and lottery tickets

Investors are motivated by goals

Investors consider their portfolio as a pyramid of distinct layers, not as a whole

Behavioral Portfolio Theory

Mean-Variance Portfolio TheoryIt all mixes in the stomach

Investors want highly nourishing and low cost meals.

Behavioral Portfolios Portfolios from the perspective of the palate as well as the perspective of the stomach. Investors want highly nourishing and low cost meals. But they also want

palatable meals.

Behavioral portfolio theory

A LOT more risk with SOME of your money

Satellite

Core

Behavioral Portfolio Theory Downside protection

vs. Upside potential?

Low risk vs. high risk?

(Risk budget)

Passive vs. active?

Diversified vs. concentrated?

Satellite

Core



Retirement

Children’s Education

Travel

Charity

Behavioral Portfolio TheoryDifferent probabilities

for different goals

Financial advisors should create portfolios

that distinguish downside protection from upside potential

and offer sure downside protection along with

some upside potential.

I have some chance of upside potential

(20% chance)

I’m virtually sure that my downside is protected(Almost 100% chance)


Focus on goalsYear Retireme

ntChild’s

Education

Travel Charity

12 $30,000 $5,0003 $30,0004 $70,000 $30,000 $1,000 $5,0005 $70,000 $30,000 $1,0006 $70,000 $10,000 $5,000… $70,000 $1,000

46

Someone’s going to win the lottery.Just not you.

It’s time for E*Trade

Behavioral Portfolio TheoryGoals, hopes, fears and aspirations

change over timeLate 1990s


change over timeEarly 2000s


change over time

Upside

Upside

Downside

Downside

Late 1990s

Early 2000s

Financial PhysiciansAspirations

Investors aspire to be rich. (Greed)

Investors aspire to be secure. (Fear)

Don’t let your investors fluctuate between greed and fear.

Don’t let your investors fluctuate between lottery tickets and money

market funds

Financial Physicians promote wealth and well-being

Make science your ally

Emotions affect attitudes toward risk

Fear Take less risk

Damasio Clip Here

Make science your allyEmotions affect attitudes

towards risk

Fear Take less riskAnger Take more riskOptimism Take more riskPessimism Take less risk

Third Lesson for investorsProtect yourself - Make your

financial advisor your ally

Good financial advisors are like good physicians. The educate and

sometimes nudge.

Good financial advisors promote both wealth and well-being.

Wealth and Well-Being

The Story of Jim Clark of Silicon Graphics, Netscape and Healtheon

(A man with a billion dollars in 1999)

“I just want to have more money than Larry Ellison. I don’t know why.”

Jim Clark of Silicon Graphics, Netscape and Healtheon in an interview with Michael Lewis, New York Times, October 10,

1999.

Larry Ellison is richLarry Ellison’s expenses

1) Life Style -- annual $20m2) Interest Accrual -- annual $75m3) Villa in Japan -- $25m4) New Yacht -- $194m -- over 3 yrs5) America's Cup -- $80m -- over 3 yrs6) UAD -- 12m over 3 yrs.

Larry Ellison is rich.

Does Larry Ellison enjoy well-being?

Larry Ellison’s quest for the perfect yacht began

four year ago after a girlfriend slighted his

80-foot sailboat Sayonara.

San Jose Mercury NewsJuly 22, 2000

“That’s a yacht!” she exclaimed, pointing to a larger white luxury craft

floating nearby.

“She made me feel terribly inadequate,”

“As a result, I went on a search to reclaim my

adequacy.”

Wealth and Well-BeingLarry Ellison got married

Well-being is high when:• Our positions are high relative

to the positions of other people.

• Our positions are high relative to our own past positions.

• Our positions are high relative to our aspired positions.

Why are the Danes so happy?On the whole are you very satisfied, fairly satisfied, not very satisfied or not at all satisfied with the life you

lead?

Denmark

EU

Very Satisfie

d

Not very

Satisfied

Not at all

Satisfied

Don’t Know

Fairly Satisfie

d

Life Satisfaction (Happiness) scale

Why are Danes so happy?

Danes have low expectations from lifeDanes’ life exceeds expectations

“And in 1992 the Danes won the European

Championship in soccer, creating ‘such a state of

euphoria that the country has not been the same

since.”NYT, January 1, 2007

Conclusion

First LessonKnow yourself - Make yourself

your ally.

Second LessonProtect yourself - Make science

your ally.

Third LessonProtect yourself - Make your financial advisor your ally.

Life Satisfaction of AdvisorsEmail from Larry Ellison’s Advisor

Reduce the concentration of Oracle in your portfolio.

• "I know this e-mail may/will depress you. • However, I believe it's my job to address

issues you'd prefer not to confront. • You told me years ago that it's OK to

raise the 'diversification issue' with you quarterly. ...

• Well, I'm doing so. • View this as a call to arms."

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Promoting the wealth and well-being of your clients: Managing risk, regret, fear and hope