It’s not the same as economically rational
Dr Meir Statman, the Glenn Klimek Professor of Finance at Santa Clara University, has done the world a huge favor. The traditional theory of economics has been based on the notion of the rational person, one who always makes financially optimal decisions. Is that me? By no means. Is it you? I’ll bet it isn’t. So, what is it that we, and people like us, do that contradicts the theory, things that the theory classifies as errors? Meir has identified those things, and calls them, quite simply, our “wants.” And our wants are generated by non-financial criteria that are important to us. So, if that’s what is prompting us, then we are “normal” people, to use Meir’s term. (You’ll notice that Meir has a knack for using language that we all understand.) And that’s OK.
It’s not just OK. It’s more than OK, it’s enough for a new branch of economics to have been developed around it. It’s called behavioral finance, and Meir is one of the pioneers in the field. And the field itself has been honored by the award of the 2017 Nobel Memorial Prize in Economic Sciences to Dr Richard Thaler, another of the pioneers. Meir has written books on the subject, a popular one being Finance for Normal People: how investors and markets behave, and I highly recommend that one in particular. Meir has been a friend for many years, and I’m proud to have a personally inscribed copy of an earlier book of his in my possession. (I say this repeatedly in these blog posts: we have no financial connection, I just have admiration for my friend.)
I was delighted that one of my favorite podcasts, The Rational Reminder, has Meir as its guest recently.
Meir explains the progress of thinking about finance. Behavioral finance noted that, in real life, people don’t focus solely on wealth in a rational way; rather, it acknowledged imperfections in their attitudes, making them (as it were) irrational. The second generation of behavioral finance considers many of those apparent imperfections as “normal” (more about what this means later); and now the third generation expands the goals behind people’s decisions beyond just financial goals, to goals involving wellbeing, because money is for more than financial wealth alone, it’s for wellbeing, and, he explains, “wellbeing has many domains. It is family, it is friends, it is work, it is health, it is religion and values, it is society.”
When I heard Meir say this, I was immediately reminded of someone else who explained this concept, Dr Ed Jacobson, about whom I’ve also written. Ed talked about our “life’s abundance portfolio,” the components of which I remember in pairs: family and friends; work and play; physical and mental health (including spirituality); and money. Yes, that’s exactly what Meir means by wellbeing. Money, as Meir says, enhances wellbeing; it also underlies wellbeing in all the other domains.
Meir draws it all together by telling us clearly that we like three kinds of benefits: utilitarian (it benefits us in a practical way), emotional (it has a direct impact on our happiness) and expressive (it says something about us to the world).
I like his contrast between wants and errors. He used a humorous example in the podcast interview. Imagine you’re at a 7-Eleven, behind someone about to buy a lottery ticket, and you say: “Listen, you think the odds of winning are 1 out of 100 million; but in fact they’re 1 out of 200 million.” Will that person then say: “Whoa, now that I know that, I’m not going to buy that ticket!” Of course not – people buy lottery tickets for the emotional benefit of bringing hope for a week.
But sometimes it’s ignorance that prompts our actions. If somehow, before we act, we’re made to realize our ignorance and then decide (unlike our lottery ticket buyer) that our action is indeed an error rather than a want, then yes, we’ll change our mind. But if, realizing that our action may not be financially beneficial but we still want to do it, because it brings a non-financial benefit (a broader wellbeing benefit), then it’s a want, and not an error. And behavioral finance now accepts the validity, indeed the good sense, of that decision.
Meir also clarifies some of our financial goals. He says that we want two things in life: one is to be rich, the other is not to be poor. Again, I identify with this very strongly, personally. In my own retirement portfolio, as I’ve written often, I divide it into two parts, one being several years’ worth of spending, which I keep in cash and safe investments, with virtually no chance of it going down in (nominal) value, and the rest in the equivalent of a global equity index fund. Once Meir identified those two financial goals, it’s clear to me that my cash-like portfolio is for not being poor, at least for the next several years, while the equity investments are in the hope of becoming rich.
In his Rational Reminder interview Meir uses these simple principles to explain all sorts of investment behavior, involving dividends, not realizing losses, dollar cost averaging, hedge fund investing, and so on. I’ll let you go directly to the interview to get the explanations – they’re fascinating. The bottom line: different people come to different decisions, and as long as they make their decisions after understanding the trade-offs, that’s normal, otherwise there could be errors. Yes, even normal people make mistakes. Being educated in these matters is the solution.
One more analogy of Meir’s appealed to me enormously. I remember explaining my retirement portfolio structure to a financial adviser, who said, “I don’t care what the different buckets are for, the fact is that ultimately you have one set of assets and it’s only the combined return that matters.” The fact that I have different purposes for the buckets, and so I’m willing to accept different returns on them because they have deliberately different risk exposures, was irrelevant to this adviser; and there was nothing further to be said.
In contrast, Meir uses this food analogy. “Behavioral portfolios are where you want your steak hot, you want your mashed potatoes hot, you want your beer cold, and so on.” Aha, I thought, the fact that they all go into your stomach and get combined for digestive purposes isn’t relevant to your enjoyment: that’s beautiful!
A totally fascinating interview, including how advisers should understand their clients’ situations and motivations, and so much else. I’ll let you have the pleasure of listening to it and taking from it what’s relevant to your situation and your wants. As you can tell, I got a ton of good stuff out if it, and what you’ll get out of it will fit you rather than me.
One final note. I showed the first draft of this blog post to Meir, and he tells me that he is writing a book on life wellbeing, in other words, the third generation of behavioral finance. I can’t wait – I have no doubt it’ll be a gem!
We all have non-financial goals as well as financial goals that contribute to our overall wellbeing. Making financial decisions with our overall wellbeing in mind is not an error – it’s sensible and totally normal.
I have written about retirement planning before and some of that material also relates to topics or issues that are being discussed here. Where relevant I draw on material from three sources: The Retirement Plan Solution (co-authored with Bob Collie and Matt Smith, published by John Wiley & Sons, Inc., 2009), my foreword to Someday Rich (by Timothy Noonan and Matt Smith, also published by Wiley, 2012), and my occasional column The Art of Investment in the FT Money supplement of The Financial Times, published in the UK. I am grateful to the other authors and to The Financial Times for permission to use the material here.