You are contemplating a gift to your beloved and wonder whether it should be a red rose or $10, the price of the rose.
You are a rational person who knows a bit of finance, so here’s your thinking: A rose has no utilitarian benefits — your beloved cannot eat or drink it. A rose is also a waste. It gets tossed after a few days, once the petals drop off. A $10 bill, in contrast, can pad a savings account, or be spent now on something your intended really wants.
Such thinking might be rational, but it is pretty stupid. Following this script would surely not make you beloved. Normal people know that roses have no utilitarian benefits, but they have a lot of expressive and emotional benefits. A rose says “I love you.” Imagine yourself instead on Valentine’s Day, presenting a $10 bill as your gift.
Well, you say, this is a nice story, but what does it have to do with finance? A lot. Stocks, bonds, and all other financial products and services are like roses, watches, cars, and restaurant meals — all providing utilitarian, expressive, and emotional benefits. We miss many insights into our financial behavior and the behavior of financial markets when we think of financial products and services as providing only utilitarian benefits.
The lessons of behavioral finance guide us, for example, to ignore “sunk costs” that have already been incurred and cannot be salvaged, even when cognitive and emotional errors prod us otherwise. Professors of economics are likely to leave disappointing movies earlier than professors of biology or the humanities, acknowledging that it is best to ignore sunk time spent watching the early part of a bad movie, as that time cannot be salvaged, and not sink additional time salvageable by leaving the theater.
Learning, however, is not easy, made more difficult by mistrust of experts. A survey asked economic experts and average Americans whether they agree with statements such as “It is hard to predict stock prices.” Answers reveal that 100% of economic experts agreed, whereas only 55% of average Americans did. The mistrust is evident in the finding that the proportion of these Americans who agreed that it is hard to predict stock prices declined to 42% from 55% when told that economic experts agreed with the statement.
In fact, there is much evidence that it is difficult to forecast stock prices. Neither amateur investors, nor writers of investment newsletters and Wall Street strategists are good at predicting stock prices. Indeed, predictions of above-average returns were generally followed by below-average returns, and predictions of below-average returns were generally followed by above-average returns.
The good news is that we can transform ourselves from normal-ignorant and normal-foolish into normal-knowledgeable and normal-smart, learning the lessons of behavioral finance and applying them to reduce ignorance, gain knowledge, and increase the ratio of smart to foolish behavior on our way to what we want.
By Meir Statman
