Larry Swedroe recommends two new books for the average investor.
Larry Swedroe, Director of Research, The BAM Alliance
There are few things I enjoy as much as reading the latest information that’s shared in the world of finance. Recently, I read two new books that I recommend to those who share my love of financial literature. Below are my reviews and some important takeaways from the books.
Rich As A King
Chess Grandmaster Susan Polgar and Certified Financial Planner Douglas Goldstein, host of the personal finance radio show “Goldstein on Gelt,” have collaborated to write a delightful book, “Rich as a King: How the Wisdom of Chess Can Make You a Grandmaster of Investing.” While the book certainly won’t make you a grandmaster investor, it’s an excellent beginner’s book for either a young adult starting out on their financial journey or a novice investor. And you don’t have to be a great chess player for it to be helpful.
The strength of the book is its entertaining-yet-informative style, using dozens of analogies between chess and investing and life in general. It’s best at helping us understand the importance of having a well-developed, overall financial plan, not just an investment plan.
For example, the book provides lessons about the need to address such issues as the potential for dying early (the need for life insurance), being disabled (the need for disability insurance), longevity risk (the need for fixed annuities) and saving (the need for an emergency fund).
It also addresses many basic personal finance issues, such as avoiding credit card debt, saving early and as much as possible, taking advantage of 401(k) plans and avoiding withdrawal from them except in emergencies. It even addresses many of the behavioral errors we make, including overconfidence, and the problems such errors can cause.
Ignore The Noise
While the investment advice is also very basic, it’s both important and sound. For example, the authors explain why you should ignore the noise put out by market forecasters and hot tips from family or friends, as well as the importance of diversification (using funds rather than individual stocks) and of favoring low-cost investment vehicles. But the investment side is not the strength of the book.
The bottom line is that if you’re looking for a basic personal finance book for yourself or as a gift, “Rich as a King” provides much valuable advice in an entertaining and informative way, making it a great choice for someone who might not otherwise read what for many is a dry, though important, subject. Chess players who know little about investing, and investors who know little about chess, will both benefit from the book’s simple wisdom.
Finance For Normal People
Meir Statman is the Glenn Klimek Professor of Finance at Santa Clara University and one of the leading researchers in the field of behavioral finance. It’s a field I am fascinated with, reading every published paper I become aware of. My book, “Investment Mistakes Even Smart Investors Make and How to Avoid Them,” is mostly about the research from the field of behavioral finance. Statman’s research has been published in the Journal of Finance, Journal of Financial Economics, Review of Financial Studies, Journal of Financial and Quantitative Analysis, Financial Analysts Journal, The Journal of Portfolio Management and many others.
I was privileged to receive an advance copy of Statman’s latest book, “Finance for Normal People: How Investors and Markets Behave.” For those interested in learning about behavioral finance, it’s a tour de force in explaining how investors and managers make financial decisions (not always rationally, from an economist’s perspective) and how these decisions are reflected in financial markets.
Among the many questions he addresses are: What are investors’ wants, and how can we help investors balance them? What are investors’ cognitive and emotional shortcuts, and how can we help them overcome cognitive and emotional errors? How are wants, shortcuts and errors reflected in choices of saving, spending and portfolio construction? How are they reflected in asset pricing and market efficiency?
As Statman explains: “Behavioral finance is finance for normal people, like you and me. Normal people are not irrational. Indeed, we are mostly intelligent, and usually ‘normal-smart.’ We do not go out of our way to be ignorant, and we do not go out of our way to commit cognitive and emotional errors. Instead, we do so on our way to seeking and getting the utilitarian, expressive and emotional benefits we want. Sometimes, however, we are ‘normal-foolish,’ misled by cognitive errors such as hindsight and overconfidence, emotional errors such as exaggerated fear and unrealistic hope.”
The term “expressive benefits” refers to the fact that we may derive nonmonetary benefits from investments, conveying to us and others our values, tastes and social status (think hedge funds). “Emotional benefits” refers to how investments make us feel (think socially responsible investing).
Among Statman’s important conclusions are:
1. People are normal.
2. People construct portfolios as described by behavioral theory, in which their wants extend beyond high expected returns and low risk to include nonmonetary benefits, such as social responsibility and social status.
3. People save and spend as described by behavioral life-cycle theory, where impediments, such as weak self-control, make it difficult to find and follow the right way to save and spend.
4. Expected returns of investments are accounted for by behavioral asset pricing theory, where differences in expected returns are determined by more than differences in risk, such as levels of social responsibility and social status.
5. Markets are not efficient in the sense that prices equal their values, but markets are efficient in the sense that they are hard to beat.
6. Genetic factors explain up to 50% of the variation in susceptibility to investment errors, such as the reluctance to realize losses (contrary to the dictates of rationality, traders are prone to let their losses ride), chasing investments with high recent returns and those that are familiar (confusing “familiar” with “safe”). In other words, in some cases, we just cannot help ourselves (at least, when we act on our own).
7. In the man-versus-machine contest, quantitative models and algorithms (such as passively managed funds like index funds) outperform human judgment (which is subject to all kinds of behavioral mistakes and biases).
Statman also spends considerable time addressing one of the great puzzles in finance, the dividend puzzle: why investors prefer spending from dividends while refraining from selling stocks and spending the proceeds. It’s a puzzle because Merton Miller won a Nobel Prize in Economics partly because of his paper showing that even before considering taxes, investors should not prefer dividends to capital gains.
The solution to the puzzle combines “wants for saving and spending, cognitive and emotional shortcuts and errors, including framing, mental accounting, hindsight, regret, and self-control, and tools for correcting them, including distinctions between capital and dividends, rules that regulate saving and spending, and insights from expected utility theory and prospect theory.” If you have a preference for dividends, this chapter alone is worth the price of the book.
Another puzzle is the preference for dollar-cost averaging (DCA) versus lump-sum investing. The issue was settled for finance people in 1979 with the publication of George Constantinides’ paper, “A Note on the Suboptimality of Dollar Cost Averaging as an Investment Policy.” Both logic and simulations indicate that investors are more likely to increase their wealth with lump-sum investing, yet they practice DCA.
Among the explanations Statman provides are that investors are risk averse (a feature of prospect theory), which can deter them from buying stocks altogether. DCA can overcome loss aversion in a framework that highlights gains and obscures losses. “This way they can console themselves if share prices plunge … and even enjoy the emotional benefits of pride by the thought that they can now buy shares at lower prices. Similarly, investors mitigate their anticipated emotional costs of regret when they convert only one part of their stocks into cash today. This way they can console themselves if share prices zoom … and even enjoy the emotional benefits of pride by the thought that they can now sell the remaining shares at higher prices.”
An additional puzzle Statman addresses in detail is the annuity one: While annuities mitigate longevity risk, and we are living longer, people are nonetheless reluctant to annuitize. Statman provides the behavioral explanations for the puzzle.
Among them are the aversion to dipping into capital, the money illusion (a lump sum of $100,000 seems much larger than the equivalent in a monthly payment), availability error (images of outliving your money are not as readily available as images of death that might befall us after signing the annuity contract) and even that annuities have “the smell of death.”
My only minor quibble with the book, which provides a wealth of information on behavioral errors we make as investors, is that it reads a bit like a textbook, which it could certainly be. That said, I’m confident you will find great value in the book and learn many lessons, especially if you are willing and able to see yourself in it. Doing so will help you learn to identify your wants, correct your errors and improve your financial behavioral.
As Statman notes: “The lessons of behavioral finance guide us to know our wants. They teach us about financial facts and human behavior, including making cognitive and emotional short cuts and errors. And they guide us to balance our wants and correct cognitive and emotional errors on the way to satisfying our wants.”
Statman concludes with this recommendation: “The lesson to amateurs is to refrain from attempts at beating the market, choosing low-cost index funds instead. They should know that attempts at beating the market on their own are costly and most fail, and their attempts at beating the market by hiring beat-the market professionals are also likely to fail because fees charged by beat-the-market professionals are higher than fees of low-cost index funds.”
This commentary originally appeared May 1 on ETF.com
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