In January, Goldman Sachs Group offered shares in privately
held Facebook to a select few of its clients. A couple of weeks
later, the firm, concerned about violating U.S. securities
laws, decided to restrict the offering to non-U.S. investors.
Its American clients, however, did not leave empty-handed.
Their status is higher, and their pride greater, now that they
have been certified as members of Goldmans inner
As a professor of finance specializing in behavioral
finance, I have spent much of my career studying cognitive
errors made by investors and their misleading emotions. But
investors be they Goldman clients, currency traders or
pension fund managers are not intentionally misguided.
Rather, they lose their way as they try to make sense of the
investment benefits they seek.
Financial actions can have three types of benefits:
utilitarian, expressive and emotional. Utilitarian benefits
answer the question, What does it do for me and my pocketbook?
The utilitarian rewards of buying a watch include the ability
to tell time. The payoff of owning Facebook shares is a
potentially high return (although, with a pre-IPO company
valuation of $50 billion, that is debatable).
Expressive benefits convey to us and others our values,
tastes and status. They answer the question, What does it say
about me? A lucky Goldman client says, My status is high
enough to be selected to invest in Facebook shares.
Emotional rewards answer the question, How does it make me
feel? Insurance policies make us feel safe, lottery tickets
give us hope, and a chance to be among the first to own
Facebook shares makes us proud.
I see nothing wrong with Goldmans wealthy clients
investing $2 million or more in Facebook shares. Their money
belongs to them and, in any event, they would not lack for
bread or butter even if their $2 million were to vanish. But I
see much wrong when pension fund managers, especially those who
oversee public funds, sacrifice utilitarian investment returns
for their own expressive and emotional benefits by trading
currencies or picking alternative investments. As a taxpayer, I
will have to pay for their indulgence, helping to foot the bill
for the retirement and health benefits of public employees.
A manager of a public pension fund recently protested when I
presented my list of investment benefits. All I want is a
positive alpha, he said. Maybe so, but managers of
pension funds generate, on average, negative alphas. Gary
Brinson, L. Randolph Hood and Gilbert Beebowers 1986
article Determinants of Portfolio Performance is
celebrated for demonstrating that strategic asset allocation is
more important than tactical asset allocation and security
selection. But what it really demonstrates is that pension fund
managers generate negative alphas.
Cognitive errors and misleading emotions, including
overconfidence, blind many investors to their perverse skill at
generating negative alphas. Such failings are not unique to
individual investors; they are often joined by institutional
investors, whom Wall Street bankers flatter as being
sophisticated players, just before they are fleeced.
Goldman chief executive Lloyd Blankfein defended his
firms actions before the mortgage crisis, saying the
collateralized debt obligations and other securities Goldman
sold had delivered the specific exposure that the client
wanted to have. But Philip Angelides of the Financial
Crisis Inquiry Commission didnt buy Blankfeins
defense. He chided the Goldman CEO for taking advantage of
pension fund managers, who hold the life savings of police
officers and teachers.
Too many pension fund managers believe that they have a good
chance to win the investment game, when, in truth, they are
overconfident and unrealistically optimistic. Public funds will
never have what it takes to win against the likes of Goldman.
They should acknowledge that they will lose every game and
protect themselves by playing as few as possible.
The recent crisis induced Goldman to expand its fiduciary
duties. The firm will now hold the hands of individual
investors and less-sophisticated institutional investors,
including public pension funds, more tightly than in the past.
Perhaps Goldman and fellow financial sellers will one day also
educate buyers about the utilitarian, expressive and emotional
benefits of investments and guide them to wise trade-offs. In
the meantime, Id like to see public pension funds ask job
candidates if they enjoy the investment game and think that
they are good at it, able to pick winning managers and
investments. Candidates who answer yes should be
Meir Statman is the Glenn Klimek Professor of Finance at
Santa Clara Universitys Leavey School of Business and
author of What Investors Really Want (McGraw-Hill).