Afford Anything - The Real Reasons People Make Bad Investment Decisions, with Finance Professor Meir Statman

Episode Date: July 26, 2024

#526: Recorded LIVE on stage at the Morningstar Conference in Chicago! We chat with behavioral finance professor Meir Statman. He breaks down the differences between standard finance and behavioral finance, making it clear that understanding human behavior is an essential part of investing. Statman starts by explaining that standard finance assumes people are rational. They make decisions purely based on logic and aim to maximize wealth. However, behavioral finance sees people as normal, not always rational. We often act on emotions and cognitive shortcuts. For instance, people might prefer receiving dividends over selling shares, even if both result in the same financial gain. This is because dividends feel like income, while selling shares feels like dipping into savings. He uses a great metaphor to explain how investors view their portfolios. Think of a dinner plate: behavioral investors like their investments separated, like mashed potatoes on one side, vegetables on another, and steak in the middle. Rational investors don’t care if it’s all blended together because they only focus on the total nutrients. This shows that normal investors have different needs and want to balance safety with growth. Statman talks about the importance of diversification. He recalls a lunch with Harry Markowitz, the father of Modern Portfolio Theory, who supported the idea of having a mix of safe and risky investments. Markowitz himself had municipal bonds to avoid poverty and stocks to grow wealth. Diversifying helps investors manage risk and meet both their safety and growth needs. We then dive into how people manage money across their life cycle. Statman points out that young people know they need to save but are tempted to spend. They often control this urge by putting money into retirement accounts like 401(k)s. As people get older, they become so good at saving that they sometimes forget to spend and enjoy their money. Statman gives a funny example of his mother-in-law, who refused to replace an old sofa because she didn’t want to dip into her savings. Statman also touches on asset pricing and market efficiency. He explains that while traditional finance focuses solely on risk, behavioral finance considers other factors like social responsibility. Some investors are willing to accept lower returns to stay true to their values. Additionally, he argues that market prices do not always reflect true value, and it’s hard to predict when they will. Towards the end, we discuss the broader aspects of wellbeing. Statman emphasizes that financial wellbeing is just one part of a happy life. Family, health, work, and community are also crucial. He believes financial advisors should help clients achieve overall life wellbeing, not just financial success. For more information, visit the show notes at https://affordanything.com/episode526 Timestamps Note: Timestamps vary on individual listening devices based on advertising run times. 1:23 - Explain the differences between standard and behavioral finance. 4:30 - Discuss Harry Markowitz's influence on modern investment strategies. 6:08 - Highlight life cycle investing and saving/spending behaviors over a lifetime. 10:02 - Explore mental accounting and differentiating between income and capital. 11:14 - Talk about common trading mistakes due to cognitive errors. 14:26 - Discuss utilitarian, expressive, and emotional benefits of financial decisions. 17:41 - Explain the difference between System 1 and System 2 thinking. 21:39 - Discuss how emotions and moods impact investment decisions. 25:59 - Explore the concept of regret and how it affects financial decisions. 30:21 - Emphasize the importance of human touch in financial advising. 44:00 - Discuss the impact of AI on different industries and investment decisions. 48:24 - Highlight the need to balance financial wellbeing with overall life wellbeing. Learn more about your ad choices. Visit podcastchoices.com/adchoices

In the world of investing, we talk a lot about numbers, but when we want to understand how investors and markets behave, we need to understand behavioral finance, not just the numbers. We need to go beyond the numbers. To discuss that today, we are here with Mir Statman, an academic professor from Santa Clara University. Welcome to a live recording of the Afford Anything podcast. This is a podcast that understands you can afford anything, but not everything. Everything carries an opportunity. cost. Today, in order to better understand opportunity costs and behavior, we're in conversation here live on stage in Chicago at the Morningstar Conference with Mir Statman. Hello, thank you for joining. Thank you, Paula, and good morning to all of you around us. To kick off, could you please explain the five foundational blocks of standard finance and the five foundational blocks of behavioral finance? In standard finance, we describe people. as rational. And in behavioral finance, I describe people as normal. People like me, we are not rational, but neither are we irrational. And let me explain what I mean by rational, because in everyday

language, we talk about rational as being a synonym for smart. In finance, in economics, we define it more precisely. So Miller and Modigliani defined rational in investors as people who prefer more money to less money, seems to make sense. And the other thing is that they don't care. They are indifferent to the form of money, whether it is dividends, which is one form, or what we know as homemade dividend that is dipping into capital, selling shares to finance their consumption. So in terms of money, they are the same,

but in terms of our behavior that are not. And so Miller Modigliani said that rational people should be indifferent between dividends paid by a company and homemade dividends that you get by selling shares, but somehow people don't seem to listen to Miller and Modigliani. And so in the first generation of behavioral finance, we disposed of the second premise, which is that people are indifferent to the form.

So what you do is you differentiate income from capital. Income is okay to spend. Capital, don't dip into capital. And so creating homemade dividend involves dipping into capital. So that is the first principle or foundation block. The second has to do with portfolios. In standard finance portfolios are mean variance portfolios. In behavioral finance, they are behavioral portfolios.

Let me explain. Many years ago, I was at a conference with her, Mary Markowitz himself. And Harry Markowitz, as you know, passed away last year. He was a friend of mine. He was a mentor of mine. He was a co-author of mine. But I took that opportunity some 30 years ago to sit with him at lunch.

And I explained the difference between mean variance and behavioral portfolio theory by pointing at our place. And I said, behavioral investors. or behavioral diners, like to have their mashed potatoes on one side of the plate, their steamed vegetable on the other, and their steak in the middle. Mean variance investors don't really care. If you just take a mixer and blend it all together and you can just suck it with a straw, that is perfectly okay because all they care about is the total,

vitamins and minerals and nutrients and so on, but people care. And the thing is that Harry Marco is unlike many of disciples, he understands investors. And so he chuckled and he accepted it immediately. So one of the things in behavioral portfolios, for example, is that we divide it to satisfy two needs that we have. One is not to be poor and the other is to be rich. What Marcos himself did was he had a chunk of municipal bonds for not being poor and the rest he put in stocks. He never rebalanced. Okay, so that is behavioral portfolios. The third has to do with life cycle. In standard life cycle, What you do is you save during your working years and then you spend it such that on your last day of your life, you spend your last dollar.

But that is not what normal people do. So what is it that we do? I come back to the distinction between capital and income. When we are young, we know we have to save, but we are tempted to spend. So what do we do? We control that urge. We exercise self-control by moving money from income to capital, such as with 401K. And we keep the role of don't dip into capital.

Spend income, but don't sell from your 401K. Now, a very important point is that when people are old, when people are old, when people, People get to be retired. They are so good at saving. They are so good at self-control, they forget to spend. And so a big problem that, you know, if you think about your parents, you probably see that. Well, you know, my mother-in-law had the rickety sofa. She said, it's fine, you know, I don't really need a new one.

Eventually, my wife and her two brothers bought a new sofa, tossed out the old one, and she said, well, you are dipping into your inheritance. Indeed. The third one, the fourth one, rather, has to do with asset pricing. It's standard finance. The only thing that matters is risk. You can take more risk. You can expect higher returns. But in behavioral finance, there are other things that matter.

For example, think about socially responsible investing. Some socially responsible investing are willing to give up some returns in return to staying true to their values. And this comes back to the point of Melamodigliani that we prefer more money to less. It's not always so. That is, when you donate money to charity, you reduce your wealth, but you increase your well-being. And so this notion that all that matters is risk is wrong. That is we also have things like social responsibility or status. Ask yourself, why is it that people buying hedge funds?

they say returns, but we know that that is not true. But hedge funds are prestigious. If you tell somebody in a casual conversation that you are into hedge fund, what did you just say? I am a rich man. You didn't brag about it. You just drove this little hint. And now I'm getting to the notion of market efficiency.

Now, the notion of market efficiency is very confused in standards finance. What it started with is the definition that in a market that is efficient, prices always equal to value. There's no such thing as overvalued or undervalued. Now, we know that prices do deviate from value. The thing is that we don't know when. And so in the behavioral one, I distinguish two notions of market efficiency. One is that price is equal to value, and the other is that it is hard to beat the market.

The reason I buy exclusively low-cost index funds is not because I think that price equals value. It is just that I don't know when the price is going to be higher or lower than value, and that serves me well. So here they are, and you can see the difference between standard and behavioral finance. So those are five key differences between standard finance, which assumes that people are rational, and behavioral finance, which says that people are normal, not irrational, but normal. Now, I want to go back to the very first thing that you said, because in the very first building block, you talked about technically returns are returns, whether they come in the form of dividends, or whether they come in the form of selling off a portion of your portfolio,

but mentally we tend to bucket those differently. And so the mental accounting that we use technically is not rational, but cognitively it's helpful. And so that might be an example of some type of a technically it's a cognitive shortcut or a cognitive error, but it also aids in behavior. Can you elaborate on some more cognitive shortcuts or cognitive errors? Yeah. So we talk about errors. And we talk about. And we talk about for example, about people who are reluctant to dip into capital as making an error. But they are not. They are really responding to what normal people have. It is hard for me to keep track of my spending. And so if I have a rule that says spend from dividend and salary, but don't dip into capital,

I can constrain my spending. And so it is really, important to see when what we do is a shortcut and when that shortcut turns into an error. So think about trading. We have a lot of evidence indicating that people who trade a lot lose a lot. So you can say that it is an error. Now talk to somebody who trades and say, look, the scientific evidence says people trade more, lose more. So don't trade. Now, what do they do? They go on and continue trading.

So I know that it's not an error. They want something. What do they want? They want the expressive and emotional benefits of being into it. You know, we play big video games. Do you make money of video games? Why do people waste their money playing video games? For some people, trading is the equivalent of video games.

And so it is really important to distinguish what is a true error and what is a want. And sometimes people are reluctant to admit what it is they really want. So they kind of go about it. And for example, people will say, well, with hedge funds, I'm getting higher returns. No, you don't. But you get prestige. If you like that exchange, enjoy. So in both examples, you talk about how if you're involved in hedge funds or if you're actively trading,

you may not derive the utilitarian benefits of higher returns, but you do derive expressive and emotional benefits. Can you elaborate a little bit on the distinction between the three? Because one big cornerstone of behavioral finance is that when people make decisions, you know, standard finance assumes that people are making decisions. purely for utilitarian benefits. But behavioral finance understands that these emotional and expressive benefits are also massively influential in decision making. Yes.

So the first generation of behavioral finance that is in the 1980s, and I was part of it, said that people want to maximize their wealth. That is their goal. but they make mistakes in doing so. For example, distinguishing capital from income. In the second generation of behavioral finance, I say, I go beyond that. And I say, people want more than just maximizing their wealth. People in everything want utilitarian, expressive, and emotional benefits.

Think about buying your car. The utilitarian benefits of a car are safety, gas mileage, things like that. But there is more to buying a car. We also want expressive benefits, you know. I don't want something dowdy and I don't want a sports car because I'm too old for that. And there is emotional benefits, you know, a sports car will get you to, work just as a plane Toyota, but Toyota does not have that zoom-zoom feeling that you get from a car. And the same, I say, applies to financial assets. That is, stocks are products

like cars. And so when we think of stocks, they have, of course, utilitarian benefits. We care about their returns, but we also care about what they say about us and how we feel about them. And so a stock has some characteristics of a lottery ticket, you know, a stock is going to make us rich. We express ourselves as people who are ready to take risk. And of course, we get the emotional benefits when the stocks go up and the pain when they go down. And so if you just go through all of that, and if you think about, say, services of financial advisors or money managers, they provide those utilitarian benefits, but also expressive and emotional benefits. When you invest with a trusted money manager, you have that sense that I am secure. That man or woman know their craft kind of like when you go to a surgeon, you can trust.

You know that even though you are under anesthesia, they're going to cut on the right foot, not the left one. You talked earlier about some cognitive shortcuts, but I also want to talk about cognitive errors. You know, we know some of the more common errors like hindsight bias or confirmation bias or anchoring. But can you talk about, you know, there's representativeness? Talk about some of the lesser known cognitive errors that we often make when we are making decisions. So representativeness is a cognitive short-contact that can turn into an error that is judging by similarity. For example, if you look at what happened to your favorite stock or the market as a whole, and the market has been going up generally in the last month.

Then we tend to extrapolate because it feels like it is similar to an increasing market. And if it goes down, then it is similar to a market that will continue to go down. And we know this is how people make forecasts. After the market has gone up, people think it will continue to go up. and when it goes down, they believe that it will continue to go down. And so you have to be very careful and know, and let me bring the notions of system one and system two. System one is our intuition. We look at the chart of the stock or market and we say the market will go up or the market goes down.

Then we kind of pull back and we engage our system. which is a scientific one and we say what do we know from scientific investigation of trends and stocks and we know that the market goes in a random walk and so don't get too optimistic after the market is going up don't get too pessimistic when it is gone down just hold steady and so this is why you know some people think that behavior of finesse or obliterate obliterated the notion that markets are efficient. No, I behave as if markets are efficient in the sense that I don't know how to beat them. And with apologies to the money managers among them, I don't think that money managers know either. And so what I do is I just buy and hold. And then I spend my time on things more important than following the market. So my portfolio goes up, every day by many thousands or goes down by many thousands. What do I do? I shrug. But if you sure change me with $10 on some transaction, I'll go after you. And so this is how we keep our money

in those separate pockets. Speaking of being too optimistic, one thing that is notable is, you know, I've always thought of overconfidence or over optimism as just one thing, right? But there are actually multiple variants of overconfidence. There's overestimation. There's over precision. Can you talk about some of the ways in which people can be too optimistic or too confident? So there are different notions or different parts of overconfidence.

Frankly, getting into them is a bit technical. The argument usually is that people trade a whole. lot because they are overconfident. My sense of it is that people make an error before they get into overconfidence. People tend to frame trading as the equivalent of playing tennis against the practice wall. That's easy, you know. Even I can do that. I can hit the ball, can see where it is going back, position myself just right. But trading is like playing tennis against somebody on the other side of the net, perhaps Jukovic, or perhaps somebody with inside information. And so I say in every trade, there is an idiot. And if you don't know who it is, it might be you. Okay? So I don't trade.

Now, overconfidence is actually very useful. If you go on a job interviewer and the interviewer says, I have 100 resumes in front of me, why should I choose you? If you are well calibrated, you say, frankly, I don't know. I mean, not knowing the qualifications of the other people in the stack, I would say that I must be in the middle someplace, maybe number 50 or maybe number 51. That will not get you the job. What will get you the job is be overconfidence, say, I am good.

I am experienced. I have done this work before. You will not regret hiring me. You got the job. So don't tell the job interviewer that probabilistically you are right in the middle of the bell curve. Can you talk about how day-to-day fluctuations in emotion, or mood can cloud our investing decisions. When we talk about emotions, you hear often that advice.

When investing, set aside your emotions. First, this is impossible because we cannot set aside our emotions. Second, our emotions help us more than they harm us. So think, for example, about driving. on the highway and suddenly the car in front of you stops or slows down substantially. What do you do? You don't check the odds of why it is, it's of an accident or whatever. You slam on the brake.

And we are all lucky that we have the mechanism that we can do our instinctive thing slamming on the brake and that automatic system is slowing on by pumping on the brake. Those of you who are old enough remember driving lessons when you were told that you have to pump the brake. You cannot pump the brake. This is where, call it artificial intelligence or that device is going to do the job for you. Ask me the question again.

Oh, so the question was about daily fluctuations in emotion or mood or affect. How does it influence? we invest. So we have those emotions. Generally, they are useful. Sometimes they are harmful. So what we need to do is to assess them with that system too. For example, when you look at the stock market that has gone up and you just feel that it will continue to go up and you get to be very optimistic, you need to to kind of think again. So what we do, say when you're angry,

I'm sure that your mom told you what my mom told me. When angry, count till 10 before you open your mouth. Because words you say to a friend, you cannot retrieve. And that friend may not be your friend anymore. And so you have to be mindful that emotional, that emotions generally help you, but sometimes they mislead you. And so this is where you have to step away from those emotions. There are other emotions that we call cognitive emotions.

Think about pride and regret. If you have two job offers and you have to pick one, you know that you're going to open yourself to regret. And so you think about what to do. So when I got this book published that Paula mentioned, a wealth of well-being, I actually had offers from two publishers who were ready to publish it. Both of them good, both of them appealing, but I had to choose.

I chose one. I don't think that I regret it, but I don't know. You know, that you can see the kind of pain that comes with that. participated regret. And the same applies to pride. Don't take pride that is not earned. Okay, I can take a lot of risk, but regret kills me. And so I engage in devices to minimize my regret, automatic money going from my salary to 401k or 432B. That mitigates regret because I have no control over it. You know, I don't have responsibility. But I had to move a big chunk of money from one mutual fund company to another in our retirement savings account. Now, what they do is

you fill the forms, you send them in to the company, to the fund that you want the money to come from. And then they cut a physical check and they send it back. And they send it by mail, by regular mail to the other one, and that mail can take seven to ten days. What if the market zooms while my money is in cash? That anticipated regret killed me. And so once when I did that, I divided the money into chunks and did it one at a time. But that is really quite a hassle just to avoid regret. The second time, I did it all in one chunk, but I had a contract with myself.

If the market goes up while the money is in cash, don't feel regret because it's not your responsibility. And if it goes down, don't feel pride. Well, the market went down when my money was in cash. And ever since, I fight that unearned pride. that is inside me. Mayor, no, you are not smart. It is just that you were lucky this time. So raw emotion can sometimes lead to that cognitive emotion, and then that's when you have to practice intentional thinking to keep it in check. Precisely. So you have to use your thinking, that system two, to assess that system one

thinking or emotion. Sometimes you cannot, you know, when you slam on the break. But most of the time, you can. And so use that. Now, remember also that emotions are also part of emotional benefits. That is, why do you go to the movies? Don't you know movies are fiction? Those actors just pretend to be, you know, Queen Elizabeth.

or whoever it is. And you know those tricks where people fly in the air, you know that there are tricks. And yet we sit there riveted. So we derive emotional benefits. So I don't really mind when people, well, I don't invest in a socially responsible way. But I'm very understanding of people who do so.

They just want to be true to themselves, and that is how they do it. I do it by investing in index funds and then using money for charity. We just do it in different ways. Both are legitimate, but you can see how they differ. That concludes part one, which is the interview that I conducted on stage at the Morning Star Investment Conference. We're going to take a moment to hear from the sponsors who allow us to bring you this show at no cost to you. And when we come back, part two, the extended bonus track, which we recorded after the onstage interview. So what you're about to hear is the part that nobody else has heard.

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But they also have the FinTech Hustle that got them named one of America's most innovative companies by Fortune magazine. That's what being a fifth third better is all about. It's about not being just one thing, but many things for our customers. Big Bank Muscle, FinTech Hustle. That's your commercial payments of Fifth Third Better. We are back, and this is the special extended edition of the interview. Behind the scenes, we're still here in Chicago at the Morning Star Conference. I wanted to continue the conversation with you around some of what we were talking about earlier.

You know, you were talking about some of the challenges based around cognitive errors, cognitive shortcuts, some of the ways that we think. And the last thing we were discussing was emotion. There's raw emotion like anger, sadness, disgust. And that differs from cognitive emotions like regret or pride. And the way to keep at least your cognitive emotions in check is to engage in system two thinking. Those of us who have read Thinking fast and slow know the distinction between System 1 and System 2 thinking. But for the people who are listening who have never heard that concept, can you just briefly explain it? So System 2 is the system of our intuition.

It is quick and it tells us, for example, when you see a snake, first move away, before you check if it is poisonous or not. That is what fear does and it does it well. After you've stepped away, you can think about it by employing system too. There are some identifying signs on the snake as to whether it is of this kind, that is. is harmless or that kind that is poisonous. And the same applies to a quick decision to trade. So somebody says something about the stock is going to go up. Your initial instinct is, let me get in before it's too late.

Then you pause for a second and you say, wait a minute, what do I know about those tips that you get from friends? And the answer is they are useless. and they're going to cost you money. So don't do that. So system two is the scientific system. It is slow. It is cumbersome, but it is more accurate.

For most of life, system one is perfectly fine. That is when you drive, you use system one turning at the right place, stopping at the right place. But when it comes to big decisions, whether it is, in the stock market, whether it is marriage or whether it is to have kids, pause and things. We had a long time difficulty explaining to our younger daughter, who is nine years younger than her sister, that her birth was not an accident, that in fact, Nava, my wife and I were discussing it.

Nava wanted another child and I was reluctant and I'm so happy that she persuaded me to have Ruth our second child. In the first half of the show, we talked about overconfidence. But there are also problems that come from, I don't want to say under confidence, but we'll say excessive risk aversion. In the same way that there are multiple variants of overconfidence, there's overestimation, there's overprecision. there are also multiple variants of risk aversion. So there's shortfall aversion, there's loss aversion, there's variance aversion. Can you talk about the distinction between these various iterations of risk aversion? Variance aversion is the simplest. This simply says that we don't like stocks that go up and down a whole lot.

Law subversion is our tendency to assess laws. losses is more important, more painful, than gains are pleasurable. And so, you know, the standard example is that if you have an offer for a 50-50 chance to either lose $100 or gain $200, that many people would reject it, even though the odds are in your favor in the loss of $100 for most people of regular income is not really a big deal. Now, a short-fell of version is really quite different. Short-full-a-version has to do with two parts. One is where you have sustained a loss.

So, for example, you bought a stock for 50 and now it is at 40. You bought a stock at 50 because you thought that it is going to go up. It has gone down. Now you can sell it and say, hey, you know, this just did not work, but the pain of regret is going to be really great. And so you're reluctant to do that. And so we ride our losers too long. So what do you do? What many people do when they are in that loss position, they actually take a risk because if the stock is now at 40, Tomorrow, it might be at 20, or it might go back to 50 and you'll break even. And so when you are in that loss position, people actually take a lot of risk that is because

when they hold the stock, they actually take the risk that it will continue to go down. But the desire to get even is so great that we do stuff that is harmful. you can see that in the financial domain, and you can see that also in personal domains. And so the distinction might be subtle, but they are important. If a person is holding on to, you know, you bought a stock at $50, like in your example, that stock is now at $40. What a lot of people do is they try to average down. So they buy more of that stock at $40 and then even more shares at $40.

and then even more shares at $35 and more shares at $30 because they figured that way their average cost is averaging down. When is that rational and when is it not? Well, I don't think that it is smart. It is really an indication of how adverse we are to regret. When you average down, when you buy more stocks at 35. dollars, you say to yourself, my initial decision was right and my current decision to buy even more is definitely right. And so I'm going to continue on. That is about riding losers too long. What you need to do is stop, you know, as they say, if you find yourself in a hole, stop digging.

So don't do that. Although I know, I mean, I empathize with. that emotion that drives you to do that. But generally, it is not wise. You made one mistake. It's not a mistake. You know, stocks go up and down for many reasons. It might have been a wise choice just because of bad luck turned out poorly. But you don't have to compound it. You don't really have to dig in. So what happens really is that people hold on to their losers for a long time, but there comes a time when another emotion comes in and that's disgust. You say, God, I've been holding this for a year, this loser, enough of that. And so that disgust propels you to actually sell it, take that pain of regret, and move on. Or if you have another opportunity

for which you need to have the money that is in the stock, that can also propel you to do what is right, which is to realize that loss. But how do we know the distinction between falling prey to our cognitive biases versus finding something that is simply an undervalued gem? You know, here's this company that based on some analysis, you really think is worth more than what you paid for it, and yet the price keeps falling. Well, even if the price is not falling, you should always ask yourself, why is it that you think that this stock is undervalued.

And you should ask yourself, what information do you have? Do you have some special information, maybe inside information, setting aside legal issues, that tells you that this is undervalued? For example, you might be a CEO who knows that they're going to be announced some really surprising, positive news. And so he knows that it is undervalued. But if you are a regular investor with no access to that special information, whenever you feel that you have identified a stock that is undervalued, take a cold shower until that thought disappears. Because you have to remember again, in every trade there is an idiot.

And it is likely that you are going to be the idiot this time. Of course, you might be lucky, but generally you have to employ System 2. And System 2 says that even professional investors find it hard to beat the market. So why would you, a regular investor, try to beat the market? And I'm not badmouting professional investors. They actually beat the market before you count their expenses and their fees. But after that, if you're an investor in an active fund, it is not reasonable, I think, for you to think that you're going to get returns higher than you're going to get from an index fund. On the subject of index funds, the U.S. large cap funds have been on a tear lately, driven largely by a very small handful, small cohort of superstars, the Magnificent Seven.

should we be rethinking our asset allocation given the overwhelming tear that U.S. large cap has been on? So it depends on what your current asset allocation is. I don't have a large cap index fund. The index funds I'm talking about are the total stock market fund or the total international market fund. So I have in my fund the magnificent seven. So if they make up a large proportion of it and they go up, I benefit. Now, if I thought that I knew which group of stock is going to do well next time, next year, I would choose it. But I don't. And so the year before, it was energy companies that did very well.

And so if you concentrate your portfolio in energy stocks or in a magnificent seven, you might be a hero or you might be a goat. And I say a goat, yeah, a loser. And I say the nice thing about diversification is that they assure you that you're going to be average. And average is better than the bottom. Because if you put your money in one group and that group bombs, then you are in big trouble. And again, it is really important to say and know that it frees me to do other things that

matter, to teach, to do research, to write, to spend time with family and friends. Why would I want to compete with professionals? You know, this notion that I, a man in the street can compete with professionals and be in a world that is populated by people with inside information, legal or otherwise, I don't do that, you know. If Jukovic offered me a game where the loser pays $100,000 to the winner, would I enter it? You know, it is fun to play Jukovic, but not for $100,000.

What is Jukovic is a champion tennis player? No, Mark Jukovic. Even I, who is not much of a fan of sports, know the name, Djokovic. I had no idea. So it's clear that we are on the cusp of the next big technological revolution, which is AI. Should that influence the way in which we think about investing? And again, I'll go back to index funds, sector-specific bets. I mean, how should we be thinking about AI as we look at?

at the next 10, 20 years. So if you are Apple or Google or one of them, you have to think about AI because it is going to change your business model and so on. If you're an investor, you can ignore it other than find it curious, interesting, useful in your life, you know, that can help you write better maybe. Because, again, there are people who do this analysis professionally

and they asked themselves which companies are going to benefit from AI. It was surprising to many people, to me, definitely, that the industry that benefited as much as the chip industry from AI is electric utilities because AI consumes a lot of energy and that is good for the utilities. And so people who had utilities in their portfolio, of course benefited. And again, I have AI companies, chip companies, utilities, everything, but I don't try to identify which of them is going to do better. Because again, it is not that

it is impossible to do, but professionals have an advantage over me, professionals who specialize in AI, who know more than to pronounce AI. And we are in competition. We are in a tennis game with them. So when I buy, somebody is selling. And when I sell, somebody is buying. And I have to ask myself, what do I know that others don't know? And the answer for me is nothing. So I do nothing. Expanding the conversation out to the 30,000 foot view level, one of the things that you've often talked about and written about is that financial well-being is only one aspect of overall well-being. Now, financial well-being comes from being able to meet your financial obligations. What are some of the other elements of overall well-being?

When people are asked, what is most important to you in life? The typical answer is family. And that is, in fact, true. So if you think about the domains of life, the things that make you happy or sad, It will be family. Within family, you'll have dating and marriage, and you have children and grandchildren and adult children who may be down under luck. And so one thing is that you need financial well-being, as you said, you need money to support a family. A sure way to a divorce is to have no money.

But money is not enough. that is every family, I say, has points of pain. For some family, for my family, it is an older daughter who lives with mental illness. For others, it might be a sudden terrifying diagnosis of cancer that is no longer operable. For others, it might be a child, maybe an adult child who comes back home because he is getting divorced and was fired from the job. You know, every family has those points of pain. And so it is important to see that our well-being, our life-well-being, is a matter of

finances, of course, but it also family and friends and health and education and work and religion and even society that is just think about how half the country is going to be happy and half the country is going to be miserable. once the elections take place in November. It really matters a great deal to many people. You know, I'm not indifferent about it, and there are some who are, but you can see how those things that have society matter to people, whether it is income inequality or whether it is immigration,

or whether it is issues that have to do with vaccination, and so on. And so we need financial well-being to enjoy life-well-being, but it is life-well-being that we seek. So I sometimes when I speak to advisors, I say, you know, the biggest risks of life are not in the stock market. If you want real risk, get married. And if you want more risk, have children. People laugh, as you just did, because once I say that, it is obvious. you know, what new thing did you say? And yet when we speak about financial well-being, it kind of stops there instead of continuing to what really matters in life, what really

determines life well-being. Again, you need money, but money is not enough. You've often said that when people ask you about the next frontier of finance and the next frontier of behavioral finance. You don't see it as a frontier. You see it as an expanding circle. So it's multidimensional rather than linear. Can you elaborate on that? What do you mean by that? Finance has traditionally kept a very narrow circle with people who are rational, interested only in maximizing their wealth, and so on. The first generation expanded that circle and said, no, people are actually making all kinds of mistakes. They are using shortcuts, some helpful, but many times they are making mistakes. The second generation expanded it further and

said, you know, beyond shortcuts and errors, people want things that are different from just maximizing their wealth. People look for expressive and emotional benefits in addition to the utilitarian benefits of returns. And so you have to now understand socially responsible investing. When I started to work on socially responsible investing more than three decades ago, nobody was interested in it in the academic side because it said, it's irrational. You should just invest in whatever gives you more money and then you can do whatever you want with the money, but that's not part of finance, you know, maybe marketing. And practitioners were not interested in it because they said, look, I'm here to maximize your wealth. And what you do

with your wealth is your business later on. But I say it's part of finance, you know, and we have to include that because you don't understand what is going on in the world of finance without expanding it. Imagine somebody in marketing who don't understand that cars are sold on the basis of their looks and feel in addition to gas mileage and so on. Yeah, that would have been ridiculous. And then I expanded it further to say what really matters is life well-being, beyond financial well-being. Now, those expansions of the circle do not obliterate the earlier ones.

The earlier ones are still part of finance for option pricing models. You have to begin with rational investors doing arbitrage that in the process determines the price of an option. But you have to recognize that people make mistakes. People want things other than maximizing their wealth. People care about life well-being beyond financial well-being. And that just makes the field richer and more useful because financial advisors, for example, can now learn and have. tools to expand conversations with their clients about life well-being. And if you think about it, if you think about human advisors and you compare them to robo advisors, robo advisors do everything

that human advisors do, asset allocation, realizing losses, harvesting losses, and so on. So why would I need to go and pay 1% when I can pay 25 basis points to a Robo Advisor? Well, the answer is that you do that because debt advisor understands you, cares about your family, will in fact engage in conversations with you about children. you know, I mean, there are families that have so much money that for them to pay full tuition at Harvard is really a pittance. And yet the kid doesn't want to go to college anyway. You cannot even get that kid to go to community college. And so you have to know what goes on in the family. That is what you are paid for as an advisor. I liken it also to financial physicians.

You want a physician, of course, on the frontier of knowledge of medicine, but you also want somebody who has bad side manners, who can understand what you are saying. Somebody you can disclose things that are kind of embarrassing, you know. And when you found a physician like that, you stick with that physician. And when you find an advisor like that, you stick with that advisor. This really is what gives human advisors the comparative advantage over robber advisors. And I think that advisors who don't understand that, one, they are changing themselves now,

but in the long run, they're going to be washed out of the profession, because what the usual stuff they do, pie charts and so on, that's generic. people are not going to pay for it what human advisors charge. Would it then be accurate to say that in this era of increasing AI and increasing automation, that that human touch, that human connection becomes more valuable than ever and also becomes our unique differentiator? Absolutely. The thing is that AI can write many things, but you still need people to read it.

there are still people at the other end of it. You don't want AI to be reading what another AI wrote. And so it really means that human touch matters even more. One advisor told me many years ago about a couple that came to him and they said, before you start planning for us, you should know that we have a disabled son. and you have to plan for him. So he's supported long after we are gone before you plan for us. Now here's a case where somebody disclosed something painful right at the beginning.

But not everyone does. You know, not everyone will tell you about a daughter who faces shaky marriage that might well collapse and that she has not enough resources to live on her own, and you might have to take her in or support her financially. All of these have human aspects, but also have financial aspects. You have to figure out a trust arrangement. You have to figure out the resources that you're going to have for the daughter, who is coming back, and so on.

Advisors who just limit themselves to the financials will never get there. And eventually, clients are going to say, so I went there and my client told me what he thought about the Federal Reserve and who is going to win the election. Well, I don't need to pay 1% of my portfolio for that. But if I have an advisor who knows because he was interested enough and he guided me to disclose what goes on in my family, what goes. on in my work, what is going on in my health. All of those have financial aspects, but they have more than that. And then I say, I found a financial physician. I found somebody who is on the frontier of knowledge of finance, but who speaks to be

as a person. And so, you know, when you go to a physician and you get a very bad diagnosis, of course, that is painful. But if you are with a good physician, that physician is going to explain what it really involved, lay out the options, show empathy for your situation, and so on. And so you leave the office, of course, broken, but know that some things can be mended, whereas somebody else is looking at his computer screen where he says, well, you have a non-operable cancer fellow. These are the differences between speaking to a person and speaking with a machine who pretends to be a person.

So then to circle all the way back to what we talked about at the beginning, it sounds as though machines can provide utilitarian benefits, but humans can provide expressive and emotional benefits. Yes, that is a good way of describing it. I think eventually for life well-being, you need the human touch. That is, you cannot have computers create friendship. You know, they can put you in touch with somebody. But for friendship, you have to spend time with a friend.

For work, you have to strive for work that pays the bills, but also provides expressive and emotional benefits. So if you are a financial advisor, you want to be one who goes home and says, I helped a client today, not just plan his or her financial future, but also help them live better. For example, persuading somebody who has millions, many millions, to part with that portions of that money and support children or grandchildren when they are in their 20s, rather than leave it to them when you die at 95 and the kid is 65, that really is part of what financial physicians do.

That is what well-being advisors do. And I'd like to point out that if you persuade an older person to support their younger children, their young adults, now rather than leave it to them as an inheritance, many adult children switch to another advisor when their parents die, because they say, this fellow does not really understand that.

If they know that you persuaded their parents to give you some money for down payment on a house or pay off your student loans, maybe they'll remember that in your favor and keep you as their advisor. Thank you to Professor Muir Statman, What are three key takeaways that we got from this conversation? Key takeaway number one.

Professor Statman explains the differences between behavioral finance and standard finance, emphasizing that while standard finance assumes that people are rational, behavioral finance recognizes that people are normal. And normal people often act on their emotions. Normal people take cognitive shortcuts and use mental models and heuristics. In standard finance, we describe people as rational. And in behavioral finance, I describe people as normal. People like me, we are not rational, but neither are we irrational.

The distinction between standard finance and behavioral finance, that's the first major takeaway. Key takeaway number two. Professor Statman highlights the significance of diversification in an investment portfolio. He uses a metaphor to explain that while rational investors will focus slowly on returns, and I'm using rational in air quotes here, right? While air quotes rational investors focus solely on returns, normal investors, real people, care about the separation of different types of investments in order to meet multiple needs, which is kind of an academic way of saying start with the end in mind.

behavioral investors or behavioral diners like to have their mashed potatoes on one side of the plate, their steamed vegetable on the other, and their steak in the middle. That is the second key takeaway. Finally, key takeaway number three. Professor Statman emphasizes that financial well-being is really one element. It's a critical element, but it is only one element of overall. life well-being, because life-well-being also includes family, health, and personal fulfillment. So financial well-being is necessary but not sufficient. As people who are in the financial

wellness space, right, we should be considering overall life-well-being. We should be considering these broader aspects as part of our financial calculations. Finance has traditionally kept a very narrow circle with people who are rational, interested only in maximizing their wealth, and so on. Those are three key takeaways from this conversation with Professor Mir Statman, who is renowned in the world of behavioral finance. And this interview was recorded at the Morningstar Investment Conference in Chicago, where Professor Statman was a speaker. It was a huge honor to record this podcast live on stage at the Morning Star Investor Conference and to meet such incredible financial advisors, investment analysts, behavioral economists, people who really deeply study this space.

And it was a great way to get a feel for what's ahead for the economy and for the future of finance. Thank you so much for tuning in. This is the Afford Anything podcast. If you enjoyed this episode, or if you enjoyed any of our other episodes, please share it with a friend, a family member, a colleague, a neighbor, a son, a daughter, a niece, a nephew, an aunt, and uncle. Share it with the people in your life. Also, follow this podcast on Spotify and Apple Podcasts. And search for us on YouTube, YouTube.com slash afford anything where you can watch videos of these interviews.

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