Meir Statman, a professor of finance at Santa Clara University and a consultant to Avantis Investors, has focused his scholarly efforts for decades on behavioral finance, and those efforts have given us a recent book on the subject, Behavioral Finance: The Second Generation.
In Statman’s view the first generation of such studies, the wave of work in behavioral finance that got underway in 1979 with a seminal paper by Kahneman and Tversky, looked for “irrational” behavior that creates, and itself constitutes, an anomaly in the classical understanding of how markets work. It sought to build a scientific study of such anomalies, but it left the classical paradigm unchallenged in critical respects. Rational profit-maximizing behavior was still considered the norm, and anything with “only behavioral” explanations was a falling-off from that norm.
Statman believes the second generation must make a more complete break, regarding non-profit-maximizing behavior by both individuals and institutions, buying, selling, or investing, as normal. It is perfectly normal to want “freedom from poverty through steady income, prospects for riches in houses of our own,” as well as to want to help one’s children, family, and friends. It is also perfectly normal to seek “shortcuts” toward these goals, which sometimes will backfire—such as buying into a bubble on a “greater fool” theory.
In this normal world, then, expected returns on investments are to be explained by a behavioral asset pricing theory, “where differences in expected returns are determined by more than just differences in risk—for example, by levels of social responsibility and social status.” In this world, too, markets are inefficient, price does not always equals value in them, but they are, so to speak, efficient enough: they are hard to beat.
Statman sees the rise of SRI/ESG investing as itself a vindication of the behavioral approach to its study. In standard finance, rational people are expected to distinguish between the pursuit of maximum return and their personal values. An investor (Smith) might well believe, say, that the marketers of alcohol are engaged in promoting alcoholism, thereby imposing a high bill on society at large. But modern portfolio theory still presumes that Smith will put his money into a well-constructed market index, even if AB InBev is one of the underlyings. Why? Because he wants to maximize return—though he may then use that return by denoting some of it to AA, or to plaintiffs’ lawyers bringing a class action suit against AB InBev and its peers for their allegedly irresponsible marketing. .
Normal people, though, even normal-smart people, don’t separate their values from their portfolios in this way. It is perfectly normal for a normal person in Smith’s situation to screen alcohol merchants out of his portfolio, inclusive of the underlyings of indexes. Because of the Smiths of the world, so-called “sin” stocks have higher risk premia and so higher returns than other stocks. Speculators can of course take advantage of this, but this is a lasting effect, not a window briefly closed by arbs.
Separately, Statman’s understanding of the new generation of behavioral finance informs his understanding of why investors put their money into hedge funds. They do so not solely because they are convinced of the rightness of the strategy of their particular fund, or the executional brilliance of its managers. They invest in hedge funds in large part because having invested in a hedge fund is a status symbol. “My last chat with my hedge fund manager” is a great topic for story telling at many tony social gatherings.
It is often observed that “alpha nets out to zero.” Indeed, it is an arithmetical necessity that it must. The whole market cannot do better than the whole market. Those who do outperform the market, then, must do so because others underperform. Many have suggested that the very existence of the industry is irrational for this reason. But even if it is irrational in the sense dear to classical economics, (and there are counter-arguments, familiar to readers of AllAboutAlpha), there would be no reason to expect that to cause the industry to disappear in a puff of logical dust: “keeping up with the Joneses” is normal, and economists should be working out models that conform to normality, without expecting normality to conform to their models.
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