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Promoting the wealth and well-being of your clients: Managing risk, regret, fear and hope Meir Statman Glenn Klimek Professor of Finance Santa Clara University.

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Presentation on theme: "Promoting the wealth and well-being of your clients: Managing risk, regret, fear and hope Meir Statman Glenn Klimek Professor of Finance Santa Clara University."— Presentation transcript:

1 Promoting the wealth and well-being of your clients: Managing risk, regret, fear and hope Meir Statman Glenn Klimek Professor of Finance Santa Clara University

2 January 1997

3 The Story of Sharon and Russ Gornie Hopes and Fears

4 Gornies Clip Here

5 Standard Finance and Behavioral Finance Standard Finance – Investors are rational. Behavioral Finance – Investors are normal.

6 We are neither rational nor irrational We are normal We know Sharon and Russ. We know their hopes. We know their fears. We know their aspirations. Can we help them?

7 It is about more than money. It is about more than risk and returns. It is about: hope fear winning stress status security It is about: life What do normal investors want?

8 Financial Physicians Physicians promote more than health. They promote health and well-being. Financial advisors are financial physicians. The promote wealth and well-being. Financial advisors manage investments. Financial advisors manage investors.

9 Financial Physicians Ask, listen, empathize Diagnose Educate Treat

10 First Lesson to investors and advisors Know Yourself Make yourself your ally Know your goals Know your emotions Know your cognitive biases

11 Second Lesson to investors and advisors Protect Yourself Make science your ally Know the science of financial markets. Know the science of human behavior.

12 Third Lesson to investors Protect Yourself Make your financial advisor your ally Good financial advisors are like good physicians. They educate and sometimes they nudge. Good financial advisors promote both wealth and well-being. Third Lesson to advisors Be a good financial physician

13 Cognitive Biases and Emotions Rome Airport

14 Cognitive Biases and Emotions Rome Hotel

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17 Cognitive Biases and Emotions Cognitive biases Framing –Size and color of Euro bills –Mental accounting (Where do the € 80 belong?) Hindsight Emotions –Embarrassment –Anger –Regret

18 Cognitive Biases and Emotions How can we overcome hindsight? How can we make peace with losses? The pain and the phantom pain of regret.

19 Cognitive biases and emotions Regret Investors overcome the pain of regret by shifting responsibility. I am not stupid. My financial advisor is stupid.

20 Financial advisors are tempted to strike back. “If we’re being honest, it was your decision to follow my recommendation that cost you money.”

21 Cognitive biases and emotions Hindsight and regret Google Cikovsky took $4,000 cash. Patterson took 16,000 stock options. 16,000 Google $85/share = $300/share = = $7,680,000

22 Cognitive biases and emotions Hindsight and regret. Why didn’t I get my $4,000 in Google options?

23 Make science your ally Combating cognitive biases and emotions Education (We are all subject to hindsight bias and regret) Cikovsky: Do I wish I’d had the shares? Yes…but what’s always in the back of my mind is an IPO is never guaranteed…and 9 out of 10 start-ups fail”

24 Wheat Bran Dietary Supplement Appears Not to Reduce Risk for Developing Pre-Cancerous Colorectal Polyps. New England Journal of Medicine (2000) Make science your ally Evidence – Based Medicine Theory, hypotheses, and empirical evidence

25 Make science your ally The science of human behavior But why do we behave as we do? Because we are intelligent We search for patterns We jump to conclusions We are affected by emotions We fall into pitfalls of cognitive biases

26 Evolutionary Psychology Darwinian Psychology Why is intuition so appealing? The scientific method as a check on intuition A brain module for recognizing faces

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29 Recognizing faces clip here

30 Of Rats and Men. Who is more intelligent?

31 Touch a button, S or B You win (money or food) if the choice is right. SB Intelligence - Searching for Patterns

32 0% 20% 40% 60% 80% 100% Men Rats Time Touching Button S BS 4/5 chance of winning 1/5 chance of winning Intelligence - Searching for Patterns Never 4/5 Always Make science your ally Are the patterns you see really there?

33 Portfolios and Asset Allocation

34 Question If you could increase your chances of having a more comfortable retirement by taking more risk, would you: a.Be wiling to take a little more risk with all your money? b.Be willing to take a lot more risk with some of your money?

35 If you could increase you chances of improving your returns by taking more risk, would you: Risk Money = x A lot more risk Some of your money Addition to portfolio risk = x All of your money A little more risk Addition to portfolio risk a. b.

36 Mean-variance portfolio theory Investors care only about risk and expected returns. Investors are averse to risk. Investors consider portfolios as a whole.

37 37 Mean-Variance Portfolio Theory

38 Investors are not always averse to risk Investors buy both insurance policies and lottery tickets Investors are motivated by goals Investors consider their portfolio as a pyramid of distinct layers, not as a whole Behavioral Portfolio Theory

39 Mean-Variance Portfolio Theory It all mixes in the stomach Investors want highly nourishing and low cost meals. Behavioral Portfolios Portfolios from the perspective of the palate as well as the perspective of the stomach. Investors want highly nourishing and low cost meals. But they also want palatable meals.

40 Behavioral portfolio theory A LOT more risk with SOME of your money Satellite Core

41 Behavioral Portfolio Theory Downside protection vs. Upside potential? Low risk vs. high risk? (Risk budget) Passive vs. active? Diversified vs. concentrated? Satellite Core

42 Behavioral Portfolio Theory

43 Retirement Children’s Education Travel Charity

44 Behavioral Portfolio Theory Different probabilities for different goals Financial advisors should create portfolios that distinguish downside protection from upside potential and offer sure downside protection along with some upside potential. I have some chance of upside potential (20% chance) I’m virtually sure that my downside is protected (Almost 100% chance)

45 Behavioral Portfolio Theory Focus on goals YearRetirementChild’s Education TravelCharity 1 2$30,000$5,000 3$30,000 4$70,000$30,000$1,000$5,000 5$70,000$30,000$1,000 6$70,000$10,000$5,000 …$70,000$1,000

46 46 Someone’s going to win the lottery. Just not you. It’s time for E*Trade Behavioral Portfolio Theory Goals, hopes, fears and aspirations change over time Late 1990s

47 Behavioral Portfolio Theory Goals, hopes, fears and aspirations change over time Early 2000s

48 Behavioral Portfolio Theory Goals, hopes, fears and aspirations change over time Upside Downside Late 1990s Early 2000s

49 Financial Physicians Aspirations Investors aspire to be rich. (Greed) Investors aspire to be secure. (Fear) Don’t let your investors fluctuate between greed and fear. Don’t let your investors fluctuate between lottery tickets and money market funds Financial Physicians promote wealth and well- being

50 Make science your ally Emotions affect attitudes toward risk FearTake less risk

51 Damasio Clip Here

52 Make science your ally Emotions affect attitudes towards risk FearTake less risk AngerTake more risk OptimismTake more risk PessimismTake less risk

53 Third Lesson for investors Protect yourself - Make your financial advisor your ally Good financial advisors are like good physicians. The educate and sometimes nudge. Good financial advisors promote both wealth and well-being.

54 Wealth and Well-Being The Story of Jim Clark of Silicon Graphics, Netscape and Healtheon (A man with a billion dollars in 1999)

55 “I just want to have more money than Larry Ellison. I don’t know why.” Jim Clark of Silicon Graphics, Netscape and Healtheon in an interview with Michael Lewis, New York Times, October 10, 1999.

56 Larry Ellison is rich Larry Ellison’s expenses 1) Life Style -- annual $20m 2) Interest Accrual -- annual $75m 3) Villa in Japan -- $25m 4) New Yacht -- $194m -- over 3 yrs 5) America's Cup -- $80m -- over 3 yrs 6) UAD -- 12m over 3 yrs.

57 Larry Ellison is rich. Does Larry Ellison enjoy well- being?

58 Larry Ellison’s quest for the perfect yacht began four year ago after a girlfriend slighted his 80-foot sailboat Sayonara. San Jose Mercury News July 22, 2000

59 “That’s a yacht!” she exclaimed, pointing to a larger white luxury craft floating nearby.

60 “She made me feel terribly inadequate,” “As a result, I went on a search to reclaim my adequacy.”

61 Wealth and Well-Being Larry Ellison got married

62 Well-being is high when: Our positions are high relative to the positions of other people. Our positions are high relative to our own past positions. Our positions are high relative to our aspired positions.

63 Why are the Danes so happy? On the whole are you very satisfied, fairly satisfied, not very satisfied or not at all satisfied with the life you lead? Denmark EU Very Satisfied Not very Satisfied Not at all Satisfied Don’t Know Fairly Satisfied

64 Life Satisfaction (Happiness) scale Why are Danes so happy? Danes have low expectations from life Danes’ life exceeds expectations “And in 1992 the Danes won the European Championship in soccer, creating ‘such a state of euphoria that the country has not been the same since.” NYT, January 1, 2007

65 Conclusion

66 First Lesson Know yourself - Make yourself your ally. Second Lesson Protect yourself - Make science your ally. Third Lesson Protect yourself - Make your financial advisor your ally.

67 Life Satisfaction of Advisors from Larry Ellison’s Advisor Reduce the concentration of Oracle in your portfolio. "I know this may/will depress you. However, I believe it's my job to address issues you'd prefer not to confront. You told me years ago that it's OK to raise the 'diversification issue' with you quarterly.... Well, I'm doing so. View this as a call to arms."

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