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November 26, 2010
Book Review: What Investors Really Want
    by Robert Kropp

Author Meir Statman argues for behavioral finance in interpreting investor behavior, and finds sustainable investment practice an effective method of incorporating expressive and emotional factors into investment decision-making.

Meir Statman, a professor of finance at Santa Clara University, claims as his area of expertise the field of behavioral finance. According to an article written by Statman in August 2010, behavioral finance offers an alternative to modern portfolio theory in describing the behaviors of individual investors and markets.

Modern portfolio theory is based on the assumptions that investors are rational and markets are efficient. Behavioral finance, on the other hand, asserts that "investors are 'normal,' not rational. Markets are not efficient, even if they are difficult to beat," according to Statman.

In his new book, "What Investors Really Want: Discover What Drives Investor Behavior and Make Smarter Financial Decisions," Statman elaborates on the tenets of behavioral finance, arguing that "normal investors" are "'normal smart' at times and 'normal stupid' at other times." The benefits of investment extend beyond the strictly utilitarian motive of making money to include expressive and emotional benefits as well.

Investors act irrationally when they fail to understand the roles that expressive and emotional motives play in their decision-making. When expressive motives lead to ostentatious displays of presumed wealth, or emotional motives lead individual investors into a fool's game of trying to consistently beat the market, the necessity for a level-headed understanding of how the market works is obscured, and the investor usually loses.

Nowhere is this dilemma better portrayed than in the individual's efforts to beat the market. "Human nature changes very slowly," Statman asserts, and he quotes an article from 1911 to support his assertion. "The very small individual investor is the most inveterate bargain hunter in the world," the editor of The World's Work is quoted as writing. "It is the small investor who always wants 100 percent cent on his money and who is willing to take the most astounding chances to get it."

Comparing index investors with beat-the-market investors, Statman describes the former as tending "to be buy-and-hold investors who trade only infrequently." In addition to enjoying returns that are equal to risk, index investors have the added advantage of low expenses.

Beat-the-market investors, on the other hand, "work hard to find investments with returns higher than their risks," according to Statman. "But cognitive errors and emotions mislead many beat-the-market investors into the belief that investments with returns higher than their risks are readily available, when, in truth, they are not."

In an
interview conducted shortly after the publication of his book, Statman explained the dilemma for individual investors who adopt a beat-the-market investment philosophy.

"Individual investors should treat the market as unbeatable and realize that when they try to beat it because it is inefficient, they are likely to injure themselves, rather than gain at the expense of another," Statman said. Furthermore, "If some people win, it means that some people lose relative to what they can get by being in an index fund. People above average tend to be the professionals and people below average tend to be individuals."

"You might say that individuals can beat the market by hiring a professional," Statman continued. "But after paying all the expenses of the money manager, they are losing."

"People should be clear what it is they want," Statman said. "If they have hope of being a winner, look for a winning mutual fund or manager, but don't try to tell me you are maximizing return to risk. You are doing it because you like the game. It's hard to admit."

If, on the other hand, investors want the highest ratio of return to risk, then "index funds are the way. If they want to be socially responsible, buy a socially responsible mutual fund."

Statman devotes a chapter of his book to sustainable investment practices. Much of the information in the chapter entitled "We Want to Stay True to Our Values" was described at length by the author in a 2008 paper entitled
The Expressive Nature of Socially Responsible Investors.

Both the chapter in Statman's book and the paper that preceded its publication relies heavily on what Statman described as "quiet conversations" with an array of sustainable investors. In keeping with the array of investment approaches described by his interviewees, Statman wrote in his book, "The differing values are reflected in the many alternatives to the term 'socially responsible investing,' including environmental, societal, and governance (ESG) investing, sustainable investing, green investing, ethical investing, mission-based investing, values-based investing, and religion-based investing."

In stating that on average, the returns of sustainable funds and mainstream funds are approximately equal, Statman refers to research of his own when he observes in his book that "the equal returns of socially responsible and conventional funds come from a balance of two opposite forces.

In his 2008 Moskowitz Prize-winning paper entitled
The Wages of Social Responsibility (co-authored by Denys Glushkov), Statman found that that positive screening for best-in-class companies increases returns, because stocks of best-in-class companies do outperform the stocks of companies that rank low. On the other hand, the stocks of shunned companies in Industries such as tobacco had higher returns than stocks of companies in other industries, and negative screening that excludes such companies reduces returns.

Therefore, according to Statman, sustainable investors who adopt the best-in-class method of positive screening can enjoy superior returns while focusing their investments on companies with strong environmental, social, or governance (ESG) records.

However, following the BP oil spill, Statman seemed to reverse himself on the preference for best-in-class positive screening, writing in a
blog post that "The socially responsible community can free itself from its bind by returning to its negative screens origins, abandoning positive screens."

Statman concluded his "quiet conversations" with sustainable investors by stating, "It is time for financial advisors to accept the preference for socially responsible investments." It would seem that the landscape for sustainable investment advice has improved since those words were written in 2008. The recently published
2010 Trends Report by the Social Investment Forum (SIF), for instance, "identified more than 725 distinct US-based investment vehicles or strategies—managed by 253 investment advisors—that incorporated ESG factors into investment management."


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