Whether to save or spend is an emotional issue for investors, says Meir Statman, who specializes in behavioral finance research and is the author of the book What Investors Really Want. Here, Statman chats with Managing Editor Lorie Konish about where investors are today and how financial advisors need to address clients' emotional outlook on the markets.

1. Where do you see investors now?
Investors are caught between hope and fear—between the desire to be rich and the fear of being poor. The risk we are willing to take is proportional to the relative desire to be rich and the fear of being poor. Different people balance it differently. If you are in your 70s and have a portfolio of, say, $1 million in stocks and the dividend yield is 2%, that means $20,000 a year to add to your Social Security amount. Well, it makes no sense. After all, somebody who is 70 might live to the late 90s, but he or she is not going to live to be 150. So this really is a time to dip into the capital. Even if you live 20 years, you can take $50,000 each year from capital without much trouble. Roughly, let's divide people into two camps: the saving kind and the non-saving kind. We know from studies of people's personalities that one aspect—conscientiousness—really matters greatly in saving. Conscientious people naturally think about tomorrow. But others don't think ahead. What we in behavioral finance try to do is to nudge non-savers toward smart behavior with techniques like automatic enrollment, for example, and escalation. But it doesn't really work for a segment at the bottom. I think we have to shove them into doing what's in their interest and really make it mandatory.

 

2. It seems that for financial advisors the challenge is dealing with multiple personalities—the client who might be in his or her 70s with money to spend who doesn't want to dip into it versus the younger client, who may be wealthy already, but really isn't the type of personality to think long term?
Exactly. Typical examples of the second kind are athletes or actors who are very successful at young ages. Many of them are smart enough at least to realize that they don't have the self-control that is necessary, and so they appoint business managers and financial advisors. When this athlete calls from a car dealership and says he wants to buy a Rolls-Royce for $200,000, the advisor says, "No." And the athlete is going to say, "But it's my money." And the advisor says, "Yes, it's your money, but I'm the one who is responsible for preventing you from doing precisely these kinds of things."

 

3. There's a lot of talk about the generation that went through the Depression having self-control. Do you see the generations that went through the recent financial crisis as being susceptible to that kind of attitude?
I don't think it will affect people nearly as much as the Depression affected people. I think that today's young people are pretty optimistic about their prospects, and I think that they're going to do well.

 

4. Are investors still having a tough time warming up to the markets?
One earlier piece of research that I did was to look at people's estimates of future returns. People tend to extrapolate from the past. So if the returns from the past few months were high, they tend to think that returns in the next 12 months will be high as well. But what affects people most is not so much what happened recently, but rather what is most vivid in their minds. What was vivid in our minds in 2010 was not that 2009 on the whole had actually been a good year, but rather that we were still shocked by the events of 2008. So that fear gripped us until recently, and for some people, it still grips them. For some people, it is another emotion—regret. Think about people who took out their money, say, in 2008 and felt like geniuses when the markets continued to go down. Of course, when the markets turned up in March 2009, they didn't buy, and now they feel like complete idiots getting into the market at current levels, knowing that they got out at much lower levels.

 

5. So, financial advisors are going to be having very emotional conversations with some of their clients?
Yes. It is difficult to tell people who are spendthrifts in their early years that they are going to find themselves penniless later on, especially when they know people who spend a whole lot more because they have more income or they are just foolhardy. And it is equally difficult to persuade older people who have a lot of money to let go. So financial advisors should be instilling some fear in exuberant people and adding a bit of exuberance to people who are fearful for no good reason.

Watch the video: Protect Investors from Their Worst Enemy: Themselves