Christine Benz: Hi, I'm Christine Benz for Morningstar. I am here at the Morningstar Ibbotson Conference, where we had the opportunity to sit down with Meir Statman. Meir is a professor of finance at Santa Clara University. He is also one of the leading lights in the realm of behavioral finance. We talked about the growth in certain asset classes and what that might say about investor psychology.
Christine Benz: Meir, thank you for being here.
Meir Statman: Delighted to be with you.
Benz: Meir, you focus on the intersection between investor emotions and behavior and their investment decision-making, and I'd like you to opine about a few categories that have recently seen a lot of investor interest, and maybe talk about what they're saying about investor psychology. So for several years running, we've seen very strong inflows into bond funds, and I'm wondering if you can talk about what you think that suggests about investor behavior?
Statman: Well, it suggests two things. One is that the emotions matters, in particular, the emotion of fear. And second, the tendency that we have to extrapolate from the past.
Now, when it comes to fear, God knows, we have reason to be afraid--2008 is several years ago, but it feels like yesterday, it feels like today. It is still more vivid than 2011, and so people are afraid that what we saw in 2008 is going to come again because of Europe, because of other things. So fear is high, and when fear is high, people are risk-averse, and when they are risk averse, they go to bonds even if their yields are minuscule.
Second has to do with extrapolation, and it's extrapolation not necessarily from the past as much as from vivid events. Generally, the immediate past is most vivid, but in our case, people still feel, as I said, that we are in 2008, and so people still think that the world is going to be like that--that stocks are always going to lose, that bonds are their safety part, and that really is going to defeat them.
Benz: And that was such as searing experience that investors went through during that financial crisis, you're saying people would rather take a safe, but low return than risk any money by investing in stocks.
Statman: Precisely. People are afraid. But remember, for most people, taking risk is not a luxury. If you're going to put your money in money market funds, you're going to earn nothing, and after inflation you're going to earn a negative return, and for longer-term bonds, it is not much better than that. So, young people have to take risk, and risk means generally investing some of the money in equities and taking the discomfort that comes with it right now.
Benz: Now, a related category that has seen some investor interest over the past couple of years is precious metals, gold in particular. Last year we had kind of a mania going on for gold. Is that a similar phenomenon? Is that fearful or is that greed or what is that?
Statman: It is fearful. I would not call people "greedy." People are afraid, and people think that gold is going to be good because gold has been good, and people think that gold is good because they think the world is coming to an end in some way, and so they want something that they are going to buy groceries with when everything collapses--they are going to buy a pound of tomatoes with a coin of gold.
Benz: So, kind of an Armageddon type scenario?
Statman: Many people feel that way. Many people are at their wits' end.
Benz: Another category that we've seen a lot of investor interest in is anything that has income attached to it. Investors seem to be saying, "I'd rather have that money in hand versus worrying about total return." What do you think that says about investor psychology?
Statman: Well, people always distinguished income from capital, and so when people think about income, they think about interest, they think about dividends. Of course, people in finance would tell them, focus on total return. You can always sell shares and create your own homemade dividends, but that is not how people think, and so investment professionals have to create for clients structures that would enable them in fact to dip into capital smartly without exhausting it, but let them live decently in their waning years.
Benz: Are you a proponent of that so-called "bucket approach" to structuring a retirement portfolio, where you've got very safe assets, maybe intermediate-term assets, and longer term assets? Do you think that makes sense?
Statman: Absolutely. The bucket approach, the mental account approach, is the natural way we think. We don't think about money in the abstract. We think of money that is associated with goals. We have a goal to have a decent retirement. We have a goal to be able to support our children. We have a goal of leaving some money for charity, and we are willing to take different kinds of risks with those different kinds of pots of money, and that makes perfect sense because it speaks clients', speaks investors' language rather than this abstract language of correlations and standard deviations.
Benz: At the other end of the spectrum, we've talked about some very safe security types that investors have preferred, or maybe things that give them the illusion of safety. Let's talk about emerging-markets stock, because that's been another category that despite very poor performance in 2011, investors continue to add new dollars there. What do you think is going on there from a psychological standpoint?
Statman: Well, I think that people think that the world is changing such that emerging markets are indeed emerging, whereas our market is declining--that the United States is declining.
Benz: ... and Europe and Japan ...
Statman: ...and Europe and Japan. And so what people don't seem to get is that the fact that the economy in emerging markets is going to boom relative to ours, it doesn't mean that stocks are going to do very well because stocks anticipate what people think now. And so there is no good reason to expect emerging markets on average to do better than developed markets adjusted for risk.
So still the best advice I can impart is diversify your portfolio, have some emerging markets, but don't overload emerging markets and make them the center of your portfolio, because you can see that they can go up big and they can go down big.
Benz: One last category, it's a very broad category I'd like to touch on, is the strong growth we've seen in exchange traded funds and other passively managed products. To me, that seems like it could be kind of a triumph of the rational. You see the typical active fund manager does not outperform market benchmarks, [so] investors seem to be making a rational decision. What do you think about that?
Statman: I think that index funds, low-cost index funds are a wonderful choice. That is my choice. Now, ETFs have been promoted as having lower costs, for example, but they don't really have lower cost or better tax benefits than just plain low-cost index funds. Some people like them because they can trade, which is really very bad for them anyway. ETFs kind of feel hip, whereas mutual funds feel like my grandfather's kind of instrument, but don't get fooled. That is, if you choose to index, that's a good idea; if you choose to trade less; that's a very good idea; if you choose to diversify, that's a very good idea. But don't think that ETFs are salvation.
Benz: Well, Meir, always great to hear your insights. It's a terrific body of work that you've assembled, and we love to sit down with you and hear what you're thinking. So, thank you so much.
Statman: Thanks, Christine. Good to be with you.