Ask retirement investors what they want from their portfolios and they are likely to say they are looking to make money to sustain them in the future. The view you get in standard finance textbooks is also all about dollars and cents: Investors are rational creatures making informed choices by weighing potential future returns against risk.
That’s very different from how other researchers see us: Over the past three decades, the burgeoning field of behavioral finance has explored the many cognitive and emotional errors that lead people into foolish behaviors and poorly performing portfolios. For example, overconfidence results in frequent trading, whose costs harm returns. The costly duo of unrealistic hope and excessive fear leads investors to pile into stocks just before market peaks and dump their stocks in market crashes.
The reality: Normal investors, people like you and me, are neither purely rational nor bumblingly irrational. We have some nonfinancial wants that drive what we do with our portfolios. While that may seem bad, it’s really okay—within reason.
The New Message of Behavioral Finance
In the current second generation of behavioral finance, we are exploring people’s nonfinancial desires and acknowledging that they have a legitimate place in our money matters. These wants can include the desire to invest in things that we are comfortable with and that are in line with our principles of social responsibility. We may also want to impress other people or have fun picking stocks.
A portfolio that satisfies such desires can look very different from one constructed solely to deliver the highest expected return for the ups and downs we are willing to stomach. Consider an analogy between investment portfolios and the “food portfolios” we know as diets.
In 1939 economist George Stigler evaluated 77 food items, from wheat flour to sirloin steaks to strawberry preserves, and found that the lowest-cost nutritionally sound diet consisted of only five foods. The full-year diet of a moderately active man weighing 154 pounds included 370 pounds of wheat flour, 57 cans of evaporated milk, 111 pounds of cabbage, 23 pounds of spinach, and 285 pounds of dried navy beans.The annual cost at the time: $39.93.
But that’s not how normal people want to eat, of course. Stigler then looked at what dietitians suggested as a healthy low-cost choice. That diet would have cost $100 in 1939, more than double the figure for Stigler’s food list. The dietitians were trying not just to meet numerical targets for nutrition at a decent price, but also to satisfy wants including palatability and variety. Hello, meat and sugar.
A Palatable Portfolio
Similarly, in managing their retirement investments, there are many ways people may want to modify the mix of securities they own to make it more palatable, even if they potentially give up some return.
For instance, a standard analysis of returns and risk might call for putting half your stock dollars into foreign shares, since they represent about half the total value of stocks around the world. To some investors, that mix is unpatriotic; others may simply feel uncomfortable investing so many dollars in stocks whose names they may not know. This preference to overweight our own country’s stocks is called “home bias,” which sounds negative, but it can more neutrally be seen as a nonfinancial want.
In another variation, some investors want to exclude certain companies—such as those associated with nuclear energy or weapons or tobacco or contraceptives—to invest in a “socially responsible” way. A survey by the Spectrem Group found that 37% of investors with a net worth of $1 million to $5 million consider social responsibility when they pick securities.
And then there are hedge funds—complex, high-fee investments available only to affluent individuals and institutions. In many recent periods, their performance has trailed that of basic, bland choices like stock index funds. But hedge funds convey high status in some social circles, and some investors value being able to say they own them.
The Bottom Line