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By Christine Benz | 09-16-2011 01:37 PM

Statman: Investors Must Step Away From Themselves

Investors should focus on what they can control to sidestep emotional and cognitive mistakes in extreme markets, says Santa Clara University finance professor Meir Statman.

Christine Benz: Hi. I'm Christine Benz for Morningstar.com.

Periods of extreme market volatility can prompt investors to act on emotion, thereby undermining their investment results.

On the phone with me to discuss some of these behavioral traps is Meir Statman. He is a professor of finance at Santa Clara University. He is also author of the book, What Investors Really Want.

Meir, thanks so much for joining me.

Meir Statman: Delighted to be with you.

Benz: So, Meir, one thing that you touch on in the book is how, as investors, we like to feel safe, and certainly, the current economic and market environments don't make anyone feel particularly safe. What are some of the behavioral traps that investors fall into at times like this?

Statman: Well, first is the issue of emotions, and our need to be aware of our emotions to be able to step aside and watch ourselves. And the emotion of the day, of course, is fear. And we know that fear causes us to be very risk-averse, very pessimistic about the future, and we tend to make mistakes along the way.

And so, in 1999 and early 2000, when the market was at the high, people felt no fear. People felt exuberant, and so they thought that the market will provide high returns with no risk, and we know what happened next. And in 2003, when the market was at the low, people were fearful, and they thought that now is not a good time to invest, and we know what happened after that. I wish I had surveyed results beyond that, but I can imagine what they would look like. And so we have to be aware of our emotions and counter them.

And the other part is the cognitive part. We tend to extrapolate from recent events or from vivid events, and I don't have to tell you what is vivid these days. What is vivid is that since 2008, we have gone down and even though it bounced up, that has not even registered. We just feel down, and so we tend to extrapolate from the past. And again, studies, what we know from science, what I know from my own work is that, while we tend to extrapolate from the past, thinking that low returns portend low returns in the future, in truth the opposite is the case--that on average, pessimism and fear are actually followed by relatively high returns rather than low returns.

Benz: So how do investors get beyond those emotional and cognitive mistakes that they tend to make, where they might be feeling irrationally pessimistic at a time like this?

Statman: Well, what is needed for us is to step away from ourselves. And fortunately, we can do that. That is, after all, we are watching a movie, and it is a scary movie, and we know that we feel scared, but we know that we don't get up and rush out of the theater. And so, people can do the same thing. That is, they can say to themselves, as I say to myself, "I am afraid," and yet I know from science that I have to temper my emotions by my reasons, and that really is important. It is not trivial, but we do that all the time, and we have to do it now.

Benz: One asset class I'd like to discuss with you, Meir, is gold. There's been such a stampede of investments into gold bullion. What's your take on that asset class? Are you concerned that investors are acting out of excessive fear?

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