At the pinnacle of the pyramid lie the most speculative investments, such as out-of-the-money call options and lottery tickets, intended for a shot at getting rich. Lopes describes planning as “applied hoping,” and she quotes Robin Pope (1983), who discusses the psychological value of such investments. Pope states that “after deciding to devote a fraction of the housekeeping funds to a weekly lottery ticket, housekeepers can dream from age nineteen to ninety-nine that they will become millionaires after the next drawing” (p. 156).
Without question, anticipation has value. Economist George Lowenstein (1987) reports an experiment where undergraduate students evaluated how much a kiss from a movie star of their choice was worth to them, depending on when the kiss was received. The students valued a kiss that would come in three days time as being worth more than a kiss received immediately, in three hours, or in one day. Why pay to wait? The opportunity to anticipate the experience.
Jonathan Clements writes a regular column for the Wall Street Journal called “Getting Going” that focuses on individual investing. In his column, he frequently quotes financial planners on the issues being discussed in this chapter. For example, a December 1997, column contains the following interesting characterization of the pyramid pinnacle: “ ‘With my clients, we set up mad-money accounts,’ says Deena Katz, a financial planner in Coral Gables, Fla. ‘That’s the money they use to buy hot stocks and go to Vegas. You should make a conscious decision about how much you’re going to speculate with.’”4 Clements recommends keeping the speculative portion of a portfolio below 5 percent. But he clearly recognizes the key emotion driving speculation. In his July 2, 1996, column he lumped lotteries and actively managed stock funds together, choosing as his headline “Hope Springs Eternal.” Whereas anticipation is the manifestation of hope along the emotional time line between decision and outcome, anxiety is the manifestation of fear.
In Lopes’s framework, the relative strengths of these two emotions, in conjunction with aspiration, determine tolerance for risk. In the context of portfolio selection, risk tolerance determines the allocation between the layers of the pyramid. The relative strengths of hope, fear, and aspiration determine the allocation between stocks and bonds.
Kenneth Fisher and Meir Statman (1997) analyze the nature of the advice that mutual fund companies provide to investors about the appropriate mix of stocks, bonds, and cash in their portfolios. These companies encourage investors who are more tolerant of risk and who have enough time to emphasize stocks in their mix. Financial planners provide similar advice. Of particular interest is the advice they offer when a major goal is financially within reach. In this situation, many planners recommend that investors consider shifting completely out of stocks.
Jonathan Clements discusses the issue of goal horizons in his December 2, 1997, column, in which he makes clear that the issue concerns whether a portfolio without stocks could deliver the returns required to achieve the investor’s goal. He states:
Would you be able to reach your investment goals with those sorts of annual returns? If not, then you really need to have at least some of your money in stocks, which have delivered over 10% a year on average since year-end 1925, according to Ibbotson Associates, the Chicago research firm.
“If you’re saving for college or retirement, stocks are really the only way to go,” argues Alan Cohn, a financial planner in Bala Cynwyd, Pa. “There’s nothing else that will provide you with that high rate of return.” On the other hand, if you don’t need high returns, then maybe you shouldn’t take the risk of being in stocks.
“We always invest for the lowest level of equity exposure possible,” says Harold Evensky, a financial planner in Coral Gables, Fla. “Some of my friends would disagree with that. They would say, if you can live with an all-equity portfolio, you should be all-equity. We say, if all you need is 60% stocks to meet your goals, we should go for 60% stocks.”5
What is the logic of avoiding equities? This is hardly a mean-variance argument. Mean-variance efficiency prescribes reducing the riskiness of a portfolio by shifting the allocation from stocks and bonds to cash but leaving the relative proportions of stocks and bonds intact. But mean-variance efficiency is ill equipped to deal both with goals and with the attendant psychological factors attached to them.
What about the emotional elements? Well, when a major financial goal is within reach, fear and aspiration combine to favor a conservative strategy. But suppose a conservative strategy virtually guarantees that an investor’s aspirations will be unmet. In this case, the desire to increase the probability of reaching her goal will induce an investor to hold equities. There is also a time horizon issue involved. Clements continues:
How long will you be investing?
Wall Street’s conventional wisdom suggests that the older you are, the less you should have in stocks. But in truth, the key factor isn’t your age, but how long you will be investing. If you plan to buy a home next month, for instance, you would be a fool to have your house down payment sitting in stocks, no matter how young you are.
Mr. Evensky offers this rule of thumb: Don’t put money into stocks unless you are more than five years from your goal. Suppose your son is nine years from college. Initially, you might put some of junior’s tuition money into stocks.
But once college is within five years, lighten up, preferably unloading the shares when the market is booming. “I’m always looking for a five-year window, during which I can decide when to sell,” Mr. Evensky says.6
What is going on here? Again, the “five-year rule” is hardly a mean-variance strategy. Again, emotional variables drive the behavior. Think about how an investor would feel if he
1. had sufficient resources to achieve a major goal that was less than five years away by investing in safe fixed income securities, but
2. continued to allocate these resources heavily in equities; and
3. at the end of the horizon for his goal, his equity investments had declined in price, and his goal had moved out of reach.
The dominant emotion in such a case would be regret. Hence moving out of stocks within five years of an attainable goal is a regret-avoidance strategy.
Frame Dependence: Mental Accounts and Priorities—Is Safety First?
Lopes (1987) discusses a splendid metaphor for portfolio choice: J. Anderson’s (1979) description of how subsistence farmers allocate their land between low-risk food crops and high-risk cash crops. Farmers first take care of subsistence needs, and then they plant cash crops. Theirs is a very risky portfolio. Why? It is the only way they have a chance at meeting the goals to which they aspire. Is there an analogy with investors? Here is Clements again, this time from his January 7, 1997, column:
A lot depends on your financial situation. If you can barely afford to make the house down payment, it would be nice to take greater risks so that you earn higher returns. But if the market turns against you, the consequences could be dire.
On other hand, if you have more than enough money to make the house down payment, shooting for higher returns is less of a risk, because you could still make the down payment even if you suffered some investment losses. Because you do have plenty of money, however, there’s also less incentive to try for higher returns. Indeed, it’s one of the ironies of investing. The rich can afford to take risks, but they don’t need to. The poor need to take risks, but they often can’t afford to.7
To what extent do investors think about their portfolios in layers, with the bottom layer earmarked for security and the top layer earmarked for potential? I ran a small survey asking eighty-one investors a series of questions that bear on this and related points. In the main, I found that investors, like the subsistence farmers described earlier, do think in terms of layers based on security and potential.8 Less than 20 percent indicated otherwise. Of Those that do layer their portfolios, 70 percent concentrate on security first, before investing for potential. Respondents are even stronger in saying that they are willing to take a fair amount
of risk on the upside, once they have adequate protection on the downside.9
A Meeting of the Ways
The emotion-based perspective of risk tolerance is very different from the perspective adopted in mean-variance analysis. Yet, the two are beginning to come together, as investors begin to use sophisticated software to make investment decisions. For example, investors can now use the Internet to obtain investment advice about their 401(k) plans. A major Internet provider of 401(k) advice is the firm Financial Engines, cofounded by Nobel laureate William Sharpe. Financial Engines software enables 401(k) investors to access the same mean-variance algorithms that Sharpe developed for institutional money managers.
But do investors think in mean-variance terms? Do they conceptualize their risk tolerance as the maximum increase in return variance that they could accept in return for a 100-basis-point increase in expected return? A June 29, 1998 article in U.S. News & World Report describes the performance measurement criterion—and it’s neither the mean nor the variance—displayed in the Financial Engines software.
The most compelling feature is that a user’s expected returns are expressed as probabilities—for example, the system might say, “You have a 41 percent chance of reaching your goal of $80,000 per year in retirement.”
By adjusting risk, contribution level, and retirement age, a user can see how different combinations affect the chance of succeeding. (Kaye and Ahmad 1998).
Lopes repeatedly stresses that when individuals consider aspiration, they focus on the probability of achieving at least the aspiration level. So being told that there is a “41 percent chance of reaching your goal” is precisely what they want to know. Hence, we have a meeting of the ways. Financial Engines software will furnish investors with mean-variance portfolios. But investors will evaluate the risk attached to those portfolios in terms of fear, hope, and aspiration.10
Security Design
British Premium Bonds resemble index-linked certificates of deposit, but with a twist. Holders of these government bonds are assured of receiving their principal. But in lieu of interest, they receive tickets to monthly lotteries that carry prizes between £50 and £250,000. A Premium Bond packages a very safe security with a lottery ticket, and it is very popular. What accounts for the attraction?
Most investors do not choose securities by ascertaining where the risk-return profiles place the securities on the mean-variance frontier. Rather, investors’ choices stem from their emotional reaction to the features promised by the securities. Those that promise safety appeal to investors whose primary emotion is fear. Securities that promise potential appeal to investors whose primary emotion is hope. But many investors are driven by both emotions; Lopes calls them “cautiously hopeful.” Think about British Premium Bonds in this light: Perhaps the popularity of these bonds stem from the fact that they address both emotional needs.
What types of securities appeal to these investors? Below are two examples, taken from a paper by Statman and me titled “Behavioral Portfolio Theory” (Shefrin and Statman 1999). Dean Witter proposes what they call the Principal Guaranteed Strategy, which they describe as follows:
“Mr. Stewart” has $50,000 to invest and a time horizon of 10 years. He is looking to add stocks to his portfolio for growth, but is concerned with protecting his principal. Based on his objectives and risk tolerance, “Mr. Stewart’s” Dean Witter Account Executive structures the Principal Guaranteed Portfolio below, which includes “buy” rated stocks from Dean Witter’s Recommended List.
To “protect” Mr. Stewart’s $50,000 investment, the Principal Guaranteed Strategy calls for the purchase, for $24,951, of a zero coupon bond with a face value of $50,000 maturing in ten years. This leaves $25,049 for stocks and brokerage commissions.
The Principal Guaranteed Strategy has a payoff pattern that appeals to both fear and hope. The bond portion ensures that, if held the full ten years, the payoff will not fall below the $50,000 initial purchase price, while the stock portion offers a chance for a gain.
Here is another example. Life USA, an insurance firm, offers Annu-a-Dex. Annu-a-Dex provides a guaranteed return of 45 percent over a seven-year horizon. An additional amount might be paid based on the performance of the stock market. Life USA describes the payoff as follows:
[Y]our principal will increase by 45% in the next seven years, market correction or not. And if the market does better than that, you get half the action. All without downside risk. You get the ride without the risk.
Annu-a-Dex is appealing to an investor whose aspiration level is 45 percent above current wealth. The payoff distribution has a floor at the aspiration level, and it offers some measure of upward potential beyond that level.11
Regret, Responsibility, and Financial Advisers
Regret is a painful experience that has already come up for discussion a couple of times. To help understand its impact on individual investors, consider the following example.
In March and early April 1997, the stock market experienced a substantial decline. At the time, there was a lot of concern expressed in the financial press about whether a crash might be at hand. Suppose that a conversation took place between you and your friends George, John, and Paul.
George had a lot of his portfolio in stocks, and on the basis of his own analysis decided to sell his stocks and buy certificates of deposit (CDs).
John was in the same situation as George, and like him, switched out of stocks and into CDs. However, John based his decision on his financial adviser’s recommendation rather than on his own analysis.
Paul has traditionally held CDs. In fact, he follows a CD rollover rule (rolling over the proceeds from a maturing CD into a new one). He had been holding some CDs that had just matured. Paul thought that the market would rebound, and he considered changing his usual practice by purchasing mutual fund shares instead of renewing his CDs. But in the end, he decided to renew his CDs.
Subsequently, the market has appreciated by 15 percent. All three investors held CD portfolios during this period. All would have been better off by buying stocks.
Now consider this: whose self-image do you think suffers the most?
• George, who traded out of stocks and into CDs based on his own analysis
• John, who traded out of stocks and into CDs based on his adviser’s recommendation
• Paul, who renewed his CDs
• nobody—self-image plays no role in these situations
When I ask this question to my classes, the typical responses I receive are as follows. About 70 percent choose George, 12 percent choose John, virtually no one chooses Paul, and 18 percent choose “nobody.”
The vast majority choose George because he has no one to blame for a decision gone wrong. George must accept one hundred percent of the responsibility. Meir Statman and I discussed this issue in an article we wrote for Psychology Today (Shefrin and Statman 1986). Presumably George, John, and Paul all regret their decision to go with CDs: After all, in hindsight all three recognize that they would have been better off had they gone with stocks. But most judge George’s pain to be the worst.
John, on the other hand, gets to blame his adviser. I would argue, in fact, that the shifting of responsibility from John to his adviser is one of the main services for which John’s adviser gets paid. Hand-holding may be every bit as important as traditional advice, if not more so.
Hardly anyone picks Paul because Paul followed what for him was a conventional strategy. Daniel Kahneman and Amos Tversky (1982) argue that people who deviate from what is for them a conventional way of acting become especially vulnerable to the pain of regret if things go badly. Why? Because regret is counterfactual. If Paul were to deviate from his conventional behavior pattern and things were to go wrong, it would be so easy to imagine having done the conventional thing. And the ease of imagining taking the appropriate action is what triggers the emotion of regret.
In this example, both George and John take actions and soon after learn that their act
ion resulted in a situation not to their liking. In short-term situations, regret is mainly associated with the taking of an action. However, when people are asked to think back over their lives, reflect on their regrets, and indicate what caused them the most regret—the things they did, or those they didn’t—what do most of them say? Psychologists Thomas Gilovich and Victoria Husted-Medvec (1995) find that people most regret the things they didn’t do. When it comes to the long-term, we most regret inaction.
Having a financial adviser enables the investor to carry a psychological call option. If an investment decision turns out well, the investor can take the credit, attributing the favorable outcome to his or her own skill. If the decision turns out badly, the investor can protect his or her ego and lower the regret by blaming the adviser. This phenomenon involves self-attribution bias. The investor attributes favorable outcomes to skill, and unfavorable outcomes to either somebody else, or just plain bad luck.
Regret is intertwined with hindsight bias, in which a person regards the events that happened as much more inevitable than they looked before the fact. For example, take Bernard Baruch, the legendary financier from the 1920s and 1930s. Martin Fridson (1998) reports that when Baruch wrote his memoirs in the 1950s he recalls having warned of the impending stock market crash of 1929. But looking back at his 1929 writings, he appears to have been as bullish as anyone was. Memory plays tricks on us. William Goetzmann and Nadav Peles (1994) find that mutual fund owners recollect that their funds performed much better than was in fact the case. Goetzmann and Peles attribute this tendency to cognitive dissonance. Not wanting to judge themselves harshly, investors simply remember beating the market.
Beyond Greed and Fear Page 18