Against the Gods: The Remarkable Story of Risk (56 page)

Keynes anticipated this question in The General Theory. After describing an investor with the courage to be "eccentric, unconventional and rash in the eyes of average opinion," Keynes says that his success "will only confirm the general belief in his rashness; and ... if his decisions are unsuccessful ... he will not receive much mercy. Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally."4

Prospect Theory confirms Keynes's conclusion by predicting which
decision you will make. First, the absolute performance of the stock
you select is relatively unimportant. The start-up company's performance as compared with Johnson & Johnson's performance taken as a
reference point is what matters. Second, loss aversion and anxiety will
make the joy of winning on the start-up company less than the pain if
you lose on it. Johnson & Johnson is an acceptable "long-term" holding even if it often underperforms.

The stocks of good companies are not necessarily good stocks, but
you can make life easier by agreeing with your clients that they are. So
you advise your client to buy Johnson & Johnson.

I am not making up a story out of whole cloth. An article in The Wall
Street Journal of August 24, 1995, goes on at length about how professional investment managers have grown leery of investing in financial
instruments known as derivatives-the subject of the next chapter-as a
result of the widely publicized disasters at Procter & Gamble and in
Orange County, California, among others. The article quotes John
Carroll, manager of GTE Corporation's $12 billion pension fund: "If
you made the right call and used derivatives, you might get a small additional return. But if you make the wrong call, you could wind up unemployed, with a big dent in your credibility as an investor." Andrew
Turner, director of research at a leading consulting firm for institutional
investors, adds, "Even if you keep your job, you don't want to get
labeled as [someone] who got snookered by an investment bank." A
major Boston money manager agrees: "If you buy comfortable-looking
... stocks like Coca Cola, you're taking very little career risk because
clients will blame a stupid market if things go wrong."

With Richard Thaler in the vanguard, a group of academic economists have responded to flaws in the rational model by launching a
new field of study called "behavioral finance." Behavioral finance analyzes how investors struggle to find their way through the give and take
between risk and return, one moment engaging in cool calculation and
the next yielding to emotional impulses. The result of this mixture
between the rational and not-so-rational is a capital market that itself fails to perform consistently in the way that the theoretical models predict that it will perform.

Meir Statman, a professor in his late forties at the University of
Santa Clara, describes behavioral finance as "not a branch of standard
finance: it is its replacement with a better model of humanity."5 We
might dub the members of this group the Theory Police, because they
are constantly checking to see whether investors are obeying or disobeying the laws of rational behavior as laid down by the Bernoullis,
Jevons, von Neumann, Morgenstern, and Markowitz.

Richard Thaler started thinking about these problems in the early
1970s, while working on his doctoral dissertation at the University of
Rochester, an institution known for its emphasis on rational theory.'
His subject was the value of a human life, and he was trying to prove
that the correct measure of that value is the amount people would be
willing to pay to save a life. After studying risky occupations like mining and logging, he decided to take a break from the demanding statistical modeling he was doing and began to ask people what value they
would put on their own lives.

He started by asking two questions. First, how much would you be
willing to pay to eliminate a one-in-a-thousand chance of immediate
death? And how much would you have to be paid to accept a one-ina-thousand chance of immediate death? He reports that "the differences
between the answers to the two questions were astonishing. A typical
answer was `I wouldn't pay more than $200, but I wouldn't accept an
extra risk for $50,000!"' Thaler concluded that "the disparity between
buying and selling prices was very interesting."

He then decided to make a list of what he called "anomalous behaviors"-behaviors that violated the predictions of standard rational
theory. The list included examples of large differences between the
prices at which a person would be willing to buy and sell the same item.
It also included examples of the failure to recognize sunk costs-money
spent that would never be recouped-as with the $40 theater ticket in
the previous chapter. Many of the people he questioned would "choose
not to choose regret." In 1976, he used the list as the basis for an informal paper that he circulated only to close friends and "to colleagues I
wanted to annoy."

Shortly thereafter, while attending a conference on risk, Thaler met
two young researchers who had been converted by Kahneman and Tversky to the idea that so-called anomalous behavior is often really normal behavior, and that adherence to the rules of rational behavior is the
exception. One of them later sent Thaler a paper by Kahneman and
Tversky called "Judgment Under Uncertainty." After reading it, Thaler
remarks, "I could hardly contain myself."' A year later, he met Kahneman
and Tversky and he was off and running.

Meir Statman began to be interested in nonrational behavior when,
as a student of economics, he noted that people reveal a tendency to
look at problems in pieces rather than in the aggregate. Even qualified
scholars in reputable journals reached faulty conclusions by failing to
recognize that the whole is the product of interaction among its parts, or
what Markowitz called covariances, rather than just a collection of discrete pieces. Statman soon recognized that the distortions caused by
mental accounting were by no means limited to the public at large.

Statman cites a case that he found in a journal about a homeowner's
choice between a fixed-rate mortgage and a variable-rate mortgage.8 The
paper dealt with the covariance between mortgage payments and the
borrower's income and concluded that variable rates were appropriate for
people whose income generally keeps pace with inflation and that fixed
rates were appropriate for people whose incomes is relatively constant.
But Statman noted that the authors ignored the covariance between the
value of the house itself and the two variables mentioned; for example,
an inflationary rise in the value of the house might make a variable-rate
mortgage easy enough to carry regardless of what happened to the homeowner s income.

In 1981, Hersh Shefrin, a colleague of Statman's at Santa Clara
University, showed Statman a paper titled "An Economic Theory of
Self-Control," which Shefrin had written with Thaler.9 The paper made
the point that people who have trouble exercising self-control deliberately limit their options. People with weight problems, for example,
avoid having a cake ready at hand. The paper also noted that people
choose to ignore the positive covariance between their mortgage payments and the value of their house as borrowing collateral; they view the
house as a "piggy bank" that is not to be touched, even though they
always have the option to borrow more against it and, thanks to home
equity loans, sometimes do.*
After reading this paper, Statman too was off and running.

A year later, Shefrin and Statman collaborated on an illuminating paper on behavioral finance titled "Explaining Investor Preference for Cash Dividends,"10 which appeared in the Journal of Financial Economics in 1984.

Why corporations pay dividends has puzzled economists for a long time. Why do they pay out their assets to stockholders, especially when they themselves are borrowing money at the same time? From 1959 to 1994, nonfinancial corporations in the United States borrowed more than $2 trillion while paying out dividends of $1.8 trillion.t
They could have avoided nearly 90% of the increase in their indebtedness if they had paid no dividends at all.

From 1959 to 1994, individuals received $2.2 trillion of the dividends distributed by all corporations, financial as well as nonfinancial, and incurred an income-tax liability on every dollar of that money. If corporations had used that money to repurchase outstanding shares in the open market instead of distributing it in dividends, earnings per share would have been larger, the number of outstanding shares would have been smaller, and the price of the shares would have been higher. The remaining stockholders could have enjoyed "home-made" dividends by selling off their appreciated shares to finance their consumption and would have paid the lower tax rate on capital gains that prevailed during most of that period. On balance, stockholders would have been wealthier than they had been.

To explain the puzzle, Shefrin and Statman draw on mental accounting, self-control, decision regret, and loss aversion. In the spirit of Adam Smith's "impartial spectactor" and Sigmund Freud's "superego," investors resort to these deviations from rational decision-making
because they believe that limiting their spending on consumption to
the amount of income they receive in the form of dividends is the way
to go; financing consumption by selling shares is a no-no.

Shefrin and Statman hypothesize the existence of a split in the
human psyche. One side of our personality is an internal planner with
a long-term perspective, an authority who insists on decisions that
weight the future more heavily than the present. The other side seeks
immediate gratification. These two sides are in constant conflict.

The planner can occasionally win the day just by emphasizing the
rewards of self-denial. But when the need arises, the planner can always
talk about dividends. As the light fixture "hides" the liquor bottle from
the alcoholic, dividends "hide" the pool of capital that is available to
finance immediate gratification. By repeatedly reciting the lesson that
spending dividends is acceptable but that invading principal is sinful, the
planner keeps a lid on how much is spent on consumption.

Once that lesson is driven home, however, investors become insistent that the stocks they own pay a reliable dividend and hold out a
promise of regular increases. No dividend, no money to spend. No
choice. Selling a few shares of stock and the receipt of a dividend are perfect substitutes for financing consumption in theory-and selling shares
even costs less in taxes-but in a setting of self-control contrivances, they
are far from perfect substitutes in practice.

Shefrin and Statman ask the reader to consider two cases. First, you
take $600 of dividend income and buy a television set. Second, you sell
$600 of stock and use the proceeds to buy a television set. The following week, the company becomes a takeover candidate and the stock
zooms. Which case causes you more regret? In theory, you should be
indifferent. You could have used the $600 of dividend income to buy
more shares of the stock instead of buying the TV. So that was just as
costly a decision as your decision to sell the shares to finance the TV.
Either way, you are out the appreciation on $600 worth of shares.

But oh, what a horror if dividends are cut! In 1974, when the quadrupling of oil prices forced Consolidated Edison to eliminate its dividend after 89 years of uninterrupted payments, hysteria broke out at the
company's annual meeting of stockholders. Typical was one question
put to the company chairman, "What are we to do? You don't know when the dividend is coming back. Who is going to pay my rent? I had
a husband. Now Con Ed has to be my husband." This shareholder
never gave a thought to the possibility that paying dividends out of
losses would only weaken the company and might ultimately force it
into bankruptcy. What kind of a husband would that be? Selling her
shares to pay the rent was not one of the options she allowed herself to
consider; the dividend income and the capital were kept in separate
pockets as far as she was concerned. As in a good marriage, divorce was
inadmissible.