Advisors Need to Understand Wants, Wealth, and Well-Being

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Meir Statman's latest book, Finance for Normal People, explores what he calls the second generation of behavioral finance. He is here with me today to discuss it.

Meir, thank you so much for being here today.

Meir Statman: Delighted to be with you, Christine.

Benz: Your latest book takes a look at what you call the second generation of behavioral finance. Let's start by discussing the first generation of behavioral finance, the precepts that underpin that whole movement.

Statman: Well, let me begin actually with standard finance. In standard finance, people are rational, computer-like rational. In the first generation of behavioral finance we turn them into irrational …

Benz: Completely irrational.

Statman: Bumbling idiots subject to all the long list of cognitive and emotional errors. And I think that we went too far. We overdosed on those cognitive errors, and it is time to really move to the middle and describe us as we are, normal people, normal knowledgeable and normal ignorant, normal smart and normal stupid, but intelligent enough to learn and to increase the ratio of smart to stupid behavior.

Let me give you an example. Think about lottery tickets. So, standard finance says rational people don't buy lottery tickets.

Benz: I don't buy lottery tickets.

Statman: First generation of behavioral finance said, irrational people buy lottery tickets. Why? Because they don't know statistics and the mathematics. The second generation of behavioral finance says people buy lottery tickets because they want hope of being rich. The group that buys the most tickets or most frequently are people between the ages of 60 and 69, perhaps because this is an age where they realize that they cannot become physicians now or start the next Google and so on and so their chance really is in getting lottery.

Now, if you ask yourself--suppose that you told somebody who does not know statistics that the odds of winning are not 1 in 100 million as he thought but 1 in 200 million. Would that person now not buy a lottery ticket? Of course not. It is just that smidgen of an opportunity between no chance and some chance that is giving people that urge to buy lottery tickets.

And so, we have to begin--and this is what the second generation of behavioral finance does--we have to begin with what people want. People want utilitarian, expressive, and emotional benefits in everything that we buy and use. And so, a lottery ticket has the emotional benefit of hope; it has the expressive benefit of, I am a player, I'm in the game; and of course, it has possibly the utilitarian benefits because somebody can win. You might actually win.

But from that you can go all the other wants. What is wealth for? It is for well-being. It is for satisfying our wants. And so, for some people, it means being true to their values and excluding stocks of companies they disapprove of for one reason or another. For some people, for all of us, crave respect and high social status. And so, we buy hedge funds. Of course, we say that it's for the returns and low risk, but I think that you just get into a casual conversation of investments and if you say to people that you are into hedge funds, they immediately know that you are rich without you having to say that. And we want to take care of our kids and we feel pride in doing that.

And so, you have to begin first with what it is that we want and then realize that we do make mistakes on the way from where we are to where we want to go to achieve our goals. But we don't do it because we are bumbling. We are doing it because we might be ignorant of how to do it better. And I hope that the book in many ways is going to help people figure out that distinction and not abandon their goals but find better ways to achieve them.

Benz: So, is one of your thoughts that people could kind of put themselves on a spectrum and say, well, I am maybe 80% rational/utilitarian and the other 20% I am thinking about more expressive or emotional benefits of investing or … ?

Statman: You can try that. But this kind of a Solomon thing, how can I divide you into two thirds and one third, I don't think that it is useful. I think that we are people. We are a bundle and we are connected. And so some wants, for example, we are embarrassed to admit. That is, we all care about status and respect, but we don't really want to admit to ourselves and others that we do, that is we buy a Mercedes-Benz because it's high quality; of course, the neighbors think that we are snobs. And so, I don't think that it is useful. I think that it is useful to think of people as normal, sometimes normal smart and sometimes stupid, and really figure out ways to satisfy all of those normal wants in ways that give them the highest level of well-being.

Benz: And you believe that there is a challenge there for the financial services industry and financial advisors in helping clients unpack some of the other goals they might have in making investments, so looking at these expressive and perhaps emotional goals that they might be trying to fulfill with their savings and investing habits.

Statman: That is right, yeah. Investment managers or investment advisors think of themselves as being distinct from financial advisors and financial planners. And many of them think of themselves as being wealth managers. Our goal is to get you the best of that can be had. But that's really not where the value is. The value is in really guiding people, like a good financial physician, to good financial health.

This means listening to them, asking them questions about what they want, listening to them, even to those wants that are not easy to express, showing them the trade-offs. Yes, you can buy hedge funds, but it will cost you this much in fees and so on. And then guide to them right choices that satisfy their wants. But this calls for a different skill set than wealth managers. You don't really need to know all the stuff about how to beat the market and take pride in that. You really have to be like a psychologist, like a social worker, like a friend, who really engage in a conversation about how is your family doing, what are the pressure points and so on. And many wealth managers are really very uncomfortable moving from this, call it, masculine view of, I'm beating the market to I'm actually helping, nursing investors on the way to financial well-being.

Benz: Meir, I really enjoyed the book. Thank you so much for being here to discuss it with us.

Statman: Thanks, Christine.

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