As an early proponent of behavioral finance, what made you veer away from standard finance?
“I have always tried to make sense of human behavior and continue to do so. There was no behavioral finance in 1980 when I started my work on it. In fact, it was only later that Hersh Shefrin and I coined the term. And I then realized how far I had veered away from standard finance. I was a student at the Hebrew University in Jerusalem in the late 1960s, in a building housing the economics and finance faculty. I majored in economics and statistics in my undergraduate program and in finance in my MBA program. Daniel Kahneman and Amos Tversky were doing their pioneering work in the building right next to mine, housing the psychology faculty. Yet none of my professors mentioned their names or referred to their work.”
“I left Israel for the PhD program at the Graduate School of Business of Columbia University not long before the October 1973 Yom Kippur War and the subsequent energy crisis. A May 1974 article in the New York Times caught my eye, describing the Con Ed shareholder meeting following the announcement that it was suspending its quarterly dividend because of the energy crisis, something it had never done since it started paying dividends in 1885. I remember being struck by the fury of the shareholders at the meeting. I knew that their emotions contradicted standard financial theory. In my finance courses at the Hebrew University, we studied the 1961 article by Merton Miller and Franco Modigliani who proved that rational investors do not care whether a company paid dividends or not, because they can create ‘homemade dividends’ by selling shares.”
“I joined Santa Clara University at the end of 1979 and, some months later, I heard Hersh Shefrin speak about his joint work with Richard Thaler on framing, mental accounting and self-control, and their relation to saving behavior. I could see the link to the dividend puzzle. Normal investors with imperfect self-control are concerned that they might give in to temptation and turn a 3% homemade dividend into a 30% homemade dividend. They bolster their self-control by framing their money into separate mental accounts, one for income and one for capital, and use a rule – ‘spend income, but don’t dip into capital’ – to prevent spending too much and saving too little. Rational investors have perfect self-control, obviating any need for framing, mental accounting and spending rules.”
“It turned out that Shefrin was thinking along the same lines and we decided to collaborate. We offered a solution to the dividend puzzle in one of our papers1 which we submitted to the Journal of Financial Economics in early 1982. We used Fischer Black’s article2 as a platform for our discussion and found out later that he would review our paper. The opening words of Black’s review still make me blush. ‘This paper is brilliant. It rings both new and true in my ears’. The editor of the journal initially hesitated, but accepted Black’s recommendation to publish the paper. Later on, Black was elected president of the American Finance Association in 1984 and accepted an offer from Shefrin and myself to organize a session. He subsequently chose to publish another paper3 by the two of us.“
What are some of the key takeaways from your three published books?
“The behavioral finance presented in these books is the second generation of behavioral finance. The first generation, starting in the early 1980s, largely accepted standard finance’s notion of people’s wants as ‘rational’ wants – restricted to the utilitarian benefits of high returns and low risk. That first generation commonly described people as ‘irrational’ – succumbing to cognitive and emotional errors and misled on their way to their rational wants.”
“The second generation describes people as normal. It begins by acknowledging the full range of their normal wants and their benefits (utilitarian, expressive, and emotional), distinguishes normal wants from errors, and offers guidance on using shortcuts and avoiding errors on the way to satisfying normal wants. People’s normal wants include financial security, nurturing children and families, gaining high social status and staying true to values. And people’s normal wants, even more than their cognitive and emotional shortcuts and errors, underlie answers to important questions of finance, including saving and spending, portfolio construction, asset pricing and market efficiency.”
What does behavioral finance say about market efficiency?
“The efficient4 market hypothesis is at the center of standard finance, and many believe that behavioral finance refutes it. Indeed, many believe that the refutal of the efficient market hypothesis is the most important contribution of behavioral finance. Confusion around this issue arises, however, when people fail to distinguish between two versions of efficient markets and their corresponding efficient market hypotheses: the price-equals-value efficient market hypothesis and the hard-to-beat efficient market hypothesis.”
“Price-equals-value-efficient markets are markets where the price of investments always equals their intrinsic value. On the other hand, hard-to-beat-efficient markets are markets wherein some investors are able to beat the market consistently, finding gaps between prices and values and earning abnormal returns over time, though most are unable to do so. As I often note, ‘yes, markets are crazy, but this does not make you a psychiatrist’.”
“Several cognitive errors underlie the belief of amateur investors that markets are easy to beat. One is the framing error. Amateur investors frame trading as playing tennis against a training wall. This is easy. But trading is playing against an opponent on the other side of the net, perhaps Novak Djokovic, or perhaps a trader with inside information. Other traders realize that they might be playing against an insider, but are overconfident in their ability to win. After all, they have never played against Djokovic. So their chance to win must be 50-50.”
How do you view sustainability in the context of behavioral finance?
“Socially responsible investing (SRI) was the name of the movement before ESG, sustainability, and more terms were coined. I found social responsibility criteria especially relevant to behavioral finance because they cannot be reasonably classified as proxies of risk or expected returns. Instead, they proxy people’s wants for the expressive and emotional benefits of staying true to their values.”
“This was an opening for discussions of the wider range of people’s wants central in the second generation of behavioral finance, such as wants for social status or fairness. My first article5 on SRI was published in the Financial Analysts Journal in 1993. I ended the article with a quote from the provost of a Quaker college who was asked why they do not invest in manufacturers of armaments. The response was ‘Our board isn’t out to change the world. We are seeking a oneness between ourselves and our Lord’.”
From an asset management industry perspective, what do you make of the general rise in sustainable investing?
“Many sustainability-focused investors want to do both good and well. They want the expressive and emotional benefits of staying true to their values, but they are unwilling to sacrifice any portion of their utilitarian returns for these benefits. In truth, they do no good, doing nothing to enhance the benefits of others and, like other active investors, they are not likely to do well, as sustainability-focused asset managers charge fees higher than index fund fees. A cynic might say that the asset management industry exploits the rise of investors’ passion for sustainability while keeping them blind to the truth.”
How do you envision the evolution of behavioral finance over the next decade?
“People often ask about the ‘frontier’ of behavioral finance. I, however, think about an ‘expanding circle’. The exploration of people’s financial cognition and emotions by functional magnetic resonance imaging (fMRI) is part of that circle, and so is the investigation of what financial advisers can do to enhance the financial standing and well-being of their clients.”