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Statman: Investors Must Step Away From Themselves

Christine Benz

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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Statman: Yes. I am--excessive fear or misjudgment. There is nothing wrong with having some gold in a portfolio. If you want to have two gold coins to rub together, go ahead, but putting a big chunk of a portfolio in gold I think is very risky. I had a colleague at the very beginning of the 1980s who thought that he should put all his money in gold and that in 20 years, one gold coin is going to pay for a year's tuition. Well, gold has been up since then, but it doesn't pay for a year's tuition.

And so, one other thing that I know from my own research is that there are some assets that we love. If we love them, then we think that they will have both high returns and low risk. And obviously, gold is an asset that many investors love today, and they think that it will have high returns as it had, extrapolated from the past, and low risk.

Well, it might have high returns or low returns in the future, but putting a big chunk of a portfolio in gold is very risky. You may end up being very rich, but you may end up being very poor. And so, a bit is OK, but don't overdo it.

Benz: Right. So, any other tips for countering those behavioral mistakes and the tendency to feel excessively fearful during a market or an economic environment like the current one?

Statman: Well, you know, I always go back to that serenity prayer about the need to change what we can change and learn to live with what we cannot change, and be able to tell the difference.

And so, we cannot change, other than through votes of citizens, what goes on in Washington, and surely we cannot change what goes on in Greece. But we can control our own behavior. We can control our own saving and consumption. We can control our own portfolios, and so, the smart thing in my view, what I'm doing is, I keep a diversified portfolio. I hope that everyday would show an increase in the value of that portfolio, but I know that this will not happen. And so, I learn to shrug. I learn to step away from myself and monitor my own emotions and thinking, such that I make smarter decisions rather than stupid ones.

Benz: Now, would you urge investors to stay away from some of the stimuli, so stay away from the business TV programs or watching their investment statements like a hawk? Should they try to reduce that activity?

Statman: It varies by person. I, for example, cannot stand a scary movie. They just get to me, and I'm one of those who is likely to rush out of the theater. But I can watch markets go up and down without it making me crazy. And so, if you feel that watching television programs and reading newspapers that show the scary things is really doing harm to you, stop doing that, and if you are able to shrug, then go ahead or perhaps go watch a scary movie, and relative to that, the world is going to look peaceful.

Benz: It seems like time horizon also has a role and a lot of seniors who are living on their portfolios, living off of their portfolios maybe have legitimate reason to be concerned. So, we have had a lot of volatility in stocks, and as you know, cash and bonds really aren't yielding very much, certainly the safe ones aren't, so what's your advice to that group of investors?

Statman: Well, the advice is to keep in mind that we want two things in life. One is not to be poor and the other is to be rich. For retired people it is not being poor that is a paramount. And so, what is important is to have not just a diversified portfolio, but a portfolio that is less risky, a portfolio that has lots of bonds even though the returns are very low, and there is really a need to calibrate consumption. Not to be overly fearful--that is, people in their 80s with large amounts of resources can easily dip into capital as much as they hate to do that, because God knows, we are not going to live forever, because you cannot live on the interest and dividends.

And so, it is really a matter of prudence, of being able to calm yourself and being able to think logically, and being able to spend from your capital not too much such that it would last you your lifetime.

Benz: Well, Meir, it's always terrific to hear your insights. Thanks so much for joining us today.

Statman: Delighted again to be with you.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.