Behaviorial Finance: What Drives Institutional Investors’ Decisions?

When it comes to ‘rational and smart decision making,’ Professor Meir Statman, author of ‘What Investors Really Want,’ explains why investors are influenced by many factors, including their own personality.

January 13, 2011 - It comes to nobody’s surprise that investors don’t always make the right decisions. When their stock picks go South, they are left with nothing but losses and regret. Do these investors make wrong choices because they lack knowledge and expertise? Not necessarily. In fact, what really keeps the investor from high stock returns is the investor himself, as Meir Statman, a behavioral economist, explains in his book

What Investors Really Want.

Personality, emotions, culture, gender and many more factors can keep an asset manager from making the rational and smart decisions that are needed to yield high returns, Statman says in a recent interview with Insitutional Investor writer Franziska Scheven.

While institutional investors have a slight advantage over individual financiers because they act within a structure of an institution, such as a committee or a forum, and are therefore checked and balanced before taking action, Statman argues that both types of investors “tend to be overconfident.”

A professor of Finance at the Leavey School of Business and the Santa Clara University, as well as Visiting Professor of Tilburg University in the Netherlands, Statman has long been attempting to understand how investors and managers make financial decisions and how these choices are reflected in financial markets. The issues he addresses include cognitive errors, hindsight errors, emotions, aspirations, risk, fear and regret of investors and how these factors influence investors’ decision making.

Institutional Investor: What can institutional investors discover about investor behavior that would help them to make smarter, more rational decisions to achieve investment success?

Statman: Asset managers know behavior finance enough to protect themselves from their own errors. But they use their knowledge of the errors of others to design products that people like, but short changed them in terms of return. If individual investors, for example , think that it is easy to beat the market, then they are being offered mutual funds or a variety of derivatives that look like they have only gains and no risk attached.

Some of the issues that institutional investors face are similar to those of individual investors. For example, institutional investors find it as difficult as individual investors to cut their losses and to realize them. The difference, however, is that institutional investors are generally aware of their reluctance to realize losses and so they prepare themselves by creating structures within their company. They are generally a step ahead in that they understand the kinds of cognitive errors and emotions that they face.

For example, traders might have a rule enforced by supervisors that all positions must be closed by the end of the trading day. This way they cannot really hide losses and carry them day after day.

Would you explain how age, gender, genetics and personality affect investments?

We know that personality affects investors and how they make decisions. There are people who are conscientious, who always come to meetings on time, have their paperwork set and do not find themselves at a loss when it comes to filing their taxes. Those people also tend to be more risk averse than other people. They are more careful, but sometimes they get to be too cautious.

And there are people who are extroverts. They enjoy the company of people and are talkative. Those people tend to be willing to take more risks.

In my survey, it shows that men generally are willing to take more risks than women. Men tend to be more overconfident than women.

Then there are differences across cultures. People in China are more willing to take risk than people in the United States. One possibility comes from culture. In China, for example, investors can afford to take more risk because they have a structure of family that is going to support them when they fail. There is more of a support system. This enables them to venture out. In the United States, it is much less so. Countries like the United States are individualistic, and countries such as China are collectivistic.

It is also possible that differences have to do with income per capita. Incomes on average are lower in China than in the United States, so Chinese take risks because they have little to loose. In the United States, people have more income so there are more severe consequences to loosing.

How can the lessons we have learned, specifically during the fiscal crisis, help us in the future?

One of the elements is the effect of fear and emotions and how we make decisions.

Fear makes investors more risk averse and they stay away from stocks, like during the recent crisis. Those who got out in late 2008 or early 2009 did not get back into buying stock in March 2009 and they well be still waiting. This is because they are too afraid. We also see the effect of how we think. We tend to extrapolate from a recent trend. Generally, after the market has gone up, investors think that it will continue to go up, and after it has gone down, people think it will continue to go down.

But this is wrong. In this particular crisis, the vividness of the losses in 2008 and early 2009 is so great that even though the market has regained more than half of its losses, people are still shaken up. At least retail investors still think that it is not safe to get back into stocks.

What role does emotions play in poor investing decisions? How can this be avoided?

When investors look at investments, it is very much like when we look at the car – before we check for the things we are told we should check, like gas mileage and safety records – we just look at the car and say “it is beautiful” or “we would never drive it.”

People approach investments in the same way, they look at Facebook and say “this is beautiful” and the future investment in Facebook would have high returns and low risks. When investors like a stock, they think it will have both, high returns and low risks. And when they hate it, they think it will have low returns and high risks. This is the affect of emotions and one should know that and guard against it.

It’s the same with the emotion of regret. We buy a stock and when it goes down rather than up, we keep holding on to it anyway, rather than realizing a loss.

This is because as long as we did not realize a loss, it is only on paper. We still have hope that we are going to break even. But when you sell the stock and realize the loss, this is also when you give up hope. This is when the emotion of regret comes in and what makes it hard for people to accept the mistake and move on with their investment life.