Professor, Deparlment of Finance
Leavey School of Business
Santa Clara University
Finance practitioners and academicsare, or should thatthe rationality-basedmarketequilibrium mod-
be, interested in the following questions: in and
elsin finance general of dividendsin particu-
.Why do investors like dividends? lar arealiveand well-or at leastin no worseshape
.Why do investors hate to realize losses? thanothercomparable in at
models economics their
level of aggregation. The framework is not so
.Why do investors prefer stocks of "good" weigheddown with anomalies that a completere-
construction behavioral/ cognitiveor otherlines)
.How are expected returns determined? or
is eitherneeded likely to occurin the nearfuture.
.What kjnds of securities do investors like? (p. 5466)
.What arethe forces that shapefinancial regu- I argue that, today, ten years after Miller spoke,
lations? standard finance is indeed so weighted down with
The range of questionsis wide. It includes investor anomalies that it makes much senseto continue the
behavior; the interaction of investors in markets, reconstructionof financial theory on behavioral lines.
which determines security prices; and the interaction Standardfinance is constructed with a few com-
of citizens in public policy arenas,which determines mon componentsthat have many uses. So is behav-
financial regulations. ioral finance. But the componentsof standard finance
Standard finance-the body of knowledge that and behavioral finance, reflecting different models of
is built on such pillars as the arbitrage principles of human behavior, aredifferent. This presentation pro-
Merton Miller and Franco Modigliani, the portfolio vides examples of the construction of behavioral fi-
construction principles of Harry Markowitz, the nanceasa framework that builds on standard finance
capital asset pricing theory of John Lintner and and replacesit.
William Sharpe, and the option-pricing theory of Proponents of standard finance often concede
Fischer Black, Myron Scholes, and Robert Mer- that their financial theory does poorly as a descrip-
ton-is so compelling because it uses only a few tive, or positive, theory of the behavior of individu-
basic components to build a unified theory, a the- als. They retreat to a second line of defense: that
ory that should provide answers to all the ques- standard finance does well as a descriptive theory of
tions of finance. the equilibrium that results from the interaction of
Few theories,however, are fully consistent with individuals in markets. For example, Miller (1986)
all the available empirical evidence, and standard wrote that, for individual investors,
finance is no exception. For example, Miller (1986) are
stocks usuallymorethan just the abstract "bun-
readily acknowledges that the observed preference dlesofreturns"of oureconomic models. Behindeach
for cash dividends is one of the "soft spots in the holding maybe a story of family business,family
current body of theory" (p. 5451). Miller goes on to quarrels, legacies divorcesettlements,
argue, however: a hostof otherconsiderations almosttotally irrele-
vant to our theories of portfolio selection. That we nore covariances and assessthe risk of an asset in
abstract from all thesestories in building our models isolation from the overall portfolio. By that rule, the
is not becausethe stories are uninteresting but be- options position is more risky, but by the rules of
cause they may be too interesting and thereby dis- Markowitz, the cashposition is the more risky one.
tract us from the pervasive market forces that should
Peoplein standard finance are rational. Peoplein
be our principal concern. (p. 5467)
behavioral finance arenormal. When offered a choice
Even the second line of defense, however, does not between a $10 bill and a $20 bill, both rational and
hold. Evidence is mounting that the capital asset normal people choosethe $20 bill. Rational people,
pricing model (CAPM), the market equilibrium the- however, are never confused by frames that make
ory by which risk and expected returns are deter- that $10 bill look like a $100 bill, whereas as Amos
mined in standard finance, is not a good description Tversky shows, normal people are often confused by
of reality. Moreover, contrary to Miller's view, I think frames.1
that financial decisions by individuals and institu- The effect of frames on choice is one part of
tions are the proper domain of finance, not merely Kahneman and Tversky's (1979) prospect theory,
stories that "distract us from the pervasive market and prospect theory is one of the components of
forces that should be our principal concern." Indeed, behavioral finance. Susceptibility to cognitive errors
a good theory of the financial behavior of individuals is a second component of behavioral finance (see
is crucial for a good theory of the equilibrium that Kahneman, Slovic, and Tversky 1982).For example,
results from the interactions of individuals in the standard investors are never fooled by the "law of
marketplace. To understand the differences between small numbers." They know that five years of return
the components from which standard finance and data on a mutual fund provide little information
behavioral finance are constructed, consider the ar- about the investment skills of the fund's manager.
bitrage principle. Standard investors also know that, as they assess the
People in standard finance are not confused by ability of the manager of a particular fund--say, the
frames. The pricing of a call option in the Black- Magellan Fund-they should take into consideration
Scholes model is a good example. The price of a call the evidence on the ability of the average fund man-
option is determined by substance: the knowledge ager to beat the market. Behavioral investors tend to
that the cash flows of an option can be replicated by a conclude that a five-year record of a fund is plenty of
particular dynamic combination of a bond and the evidence about the skills of its manager and that the
underlying stock. The fact that in one case the cash performance of the average fund manager is irrele-
flows are framed in terms of options and in the second of
vant in the assessment the skill of a particular fund
case flows are framed in terms of bonds and stocks
does not matter to standard finance investors. If the Standard-finance people are immune to prob-
option cash flows exceed the cash flows of the stocks lems of self-control. They stick to their diet plans and
and bonds, "standard investors" engage in arbitrage, find it easyto turn down tempting desserts.They also
make arbitrage profits, and move prices to equilib- stick to their savings plans and never engage in im-
rium levels where arbitrage is no longer profitable. pulse buying. Behavioral investors are subject to
Whereas standard investors are never affected temptation and, as Thaler and Shefrin (1981)noted,
by frames, "behavioral investors" are often affected they look for ways to improve their self-control.
by frames. Moreover, behavioral investors are af- Standard-finance investors are also immune to
fected by frames in a normal, predictable way. Con- the pain of regret (seeKahneman and Tversky 1982).
sider the following question: Which investment Standard-finance people feel no greater disappoint-
position is more risky? ment when they miss their plane by a minute as when
1. a $1,000 long position in U.S. T-bills or they miss it by an hour. Behavioral investors know
2. a $1,000 short position in naked call options the joy of pride and the pain of regret as they kick
on the S&P 500 Index. themselvesharder when they miss the plane by only
Most people choose the options position as the more a minute.
risky one. Someone whose overall portfolio is posi- The following sectionsdescribe how the compo-
tively correlated with the S&P SOO and who has cho- nentsof prospecttheory, cognitive errors, self-control,
sen the options position as the more risky position is and regretcan help makesenseof the world of finance
probably a behavioral investor-one who has been and answer the questionsposed at the beginning of
fooled by the frame. The options position is nega- this presentation. I begin with dividends, the issue
tively correlated with this investor's portfolio; thus, discussedby Miller (1986).
it provides a hedge and lowers overall portfolio risk.
In contrast, the T -bill position has only a zero corre-
lation with the portfolio and reduces its risk by less
lSee ProfessorTversky's presentation,pp. 2-5.
than the options position. Normal behavior is to ig-
Investor Preferences for Cash Dividends savings, but behavioral investors have to combat the
desire for dessert even when they know that vegeta-
During the energy crisis of the early 1970s, Con bles are better for their long-term welfare. Rules are
Edison, the power company in New York City, de- a good tool for self-control. "No dessertbefore vege-
cided to eliminate its dividend. At Con Edison's 1974 tables" is one such rule. "Consume from dividends
annual meeting, shareholders revolted; some cried, but don't dip into capital" is another. Recall that the
some had to be restrained from doing physical harm person who spoke for the woman at the Con Edison
to the company's chairman. Here is a typical share- meeting did not even consider the possibility of dip-
holder reaction, quoted from the transcript of the ping into capital to createhomemade dividends.
1974 meeting: Indeed, following standard finance theory can
A lady came over to me a minute ago,and she said get people into deep trouble. One person in the
to me, "Please say a word for the senior citizens." audience at the Con Edison meeting asked why
And she had tears in her eyes. And I really know stock dividends were not paid in place of cash divi-
what she means by that. She simply means that now dends "so at least the blow to stockholders by the
she will get only one check a month, and that will be omission of dividends would have been much less."
her Social Security, and she's not going to make it The chairman, in an explanation that would have
becauseyou have denied her that dividend.
made Miller and Modigliani proud, explained that
Standard-finance shareholders of Con Edison stock dividends are no more than pieces of paper
would have been upset by the energy crisis and its and that shareholders can create homemade divi-
impact on the value of Con Edison's stock, but they dends by selling a few shares.The chairman missed
would not have been angry about the decision to the point entirely. Naming the piecesof paper "divi-
eliminate the dividend. The Con Edison shareholders dends" moves them from the capital mental account
must have been behavioral investors. to a dividend mental account and allows consump-
Standard investors follow the arbitrage princi- tion without violating the rule of "don't dip into
ple of Miller and Modigliani and know that in a capital."
world without taxes and transaction costs, they In short, contrary to the precepts of standard
should be indifferent between a dollar in dividends finance, investors make important distinctions be-
and a dollar in capital. Standard investors are indif- tween dividends and capital. The distinctions are
ferent between dividends and capital because they rooted in the way they frame money in mental ac-
do not rely on company decisions to create divi- counts and the rules by which they use these frames
dends. They can create "homemade dividends" by to control savings and consumption. One cannot
selling shares. Moreover, in a world where divi- solve the dividend puzzle while ignoring the pat-
dends are taxed more heavily than capital gains, terns of normal investor behavior.
investors are actually better off when companies
refrain from paying dividends. So, why do investors
like dividends? This is the puzzle to standard fi- ~ Winners Too Early, Riding Losers Too
nance about which Black (1976) wrote. Hersh She-
frin and I have used the components of behavioral
finance to explain why investors like dividends Underlying the arbitrage principle of Miller and
(Shefrin and Statman 1984). Modigliani is the mechanismof arbitrage. An investor
A central element of prospect theory is that people who sellsa share at $100in one market and simulta-
segment their money into mental accounts. A dividend neouslybuys a share of the samecompany in another
dollar is identical to a capital dividend in standard market for $95engagesin arbitrage, with a risk-free
finance, but a dollar dividend is different from a capital gain of $5. Of course, standard-finance investors
dollar in prospect theory because the two dollars be- never leave arbitrage opportunities unexploited.
long to separate mental accounts and mental account- The tax law, especiallyas it stood before the 1986
ing is done account by account. The decline in the price changes,provided investors with the "timing" arbi-
per share of Con Edison is a loss in the capital mental trage opportunity described by Constantinides
account, and the elimination of the dividend is a loss in (1983,1984). The opportunity arises from differences
the dividend mental account. Paying the dividend in the tax rates on long-term and short-term gains
would have provided a "silver lining" lessening the and losses.Here is how it works: Imagine that you
pain even if the dividend payment had resulted in a have $10,000and you have decided to invest it in a
further decline in the price of the stock. no-load mutual fund, Fund A. You also identify Mu-
Segregating monies into mental accounts is espe- tual Fund H, whose returns are perfectly correlated
cially beneficial for people who have difficulty with with the returns on Fund A. Imagine also that the
self-control. As noted earlier, standard finance inves- "short term" is classified by the Internal Revenue
tors have no self-control difficulties in either diets or Serviceasone year, so gain and loss realizations after
one year are classified by the IRSas "long term."
You hold Fund A for a month, and as it happens, Why !Investors Prefer Stocks of GOOd
the stock market declines and your sharesare now Companies
worth $9,000,a paper loss of $1,000.Now the arbi-
Everyone has heard that beta is dead. Some say it is
trage game at the expense of the IRS begins. You
coming back; others say it is dead for good. The life
realize the $1,000paper loss by selling your sharesin or death of beta is so important becausebeta is the
Fund A and using the $9,000 in proceeds to buy center of the CAPM and the CAPM is the standard-
sharesof Fund B. The $1,000loss,asa short-term loss, finance way of understanding risk, expectedreturns,
can be offset against your regular income taxed at, and the relationship between the two.
say, 30 percent. Your "rebate" from the IRS is 30 The current state of the CAPM illustrates the
percent of $1,000, or $300. Now, imagine that you danger in the tendency of standard finance to down-
hold the $9,000in Fund B for a year and a day, and play an understanding of human behavior and con-
the value of the shares appreciates from $9,000 to centrate instead on the resulting equilibrium in
$10,000. You realize your $1,000 paper gain as a financial markets. The assumptions about human
long-term gain. You pay, say, 20percent, or $200,as behavior that underlie the CAPM are not simplified
a long-term tax to the IRS and buy $10,000 shares versions of observed behavior. Rather, they contra-
of Fund A. dict observedbehavior. For example,investors in the
Compare your situation to the situation of an world of the CAPM are assumed to agree on the
investor who held Fund A for the entire period. That expected returns of all assets. Of course, nobody
investor begins with $10,000 and ends with $10,000- believes that this assumption comeseven close to a
no gains, no losses. You, however, have $10,100 be- description of human behavior.
cause your initial $300tax rebate is $100higher than Assumptions about individual behavior might
the later $200 tax payment. This kind of arbitrage is not matter when a theory works, but the CAPM does
easy.It involves only the exploitation of a quirk in the not work. Now that Fama and French (1992)have
tax law. And, of course, standard-finance investors brought the sorry state of the CAPM to the headlines,
have no difficulty recognizing or exploiting arbitrage standard finance offers no fallback theory for ex-
opportunities. pected returns and risk. Instead, the result is data
Behavioral investors have a problem with the mining in the form of size and book-to-marketeffects.
arbitrage prescription; it requires the realization of a Shefrin and I have also observed the choices of
$1,000"paper loss" as they sell Fund A and buy Fund investors, rather than stock prices, and offered in-
B. Behavioral investors hate to realize losses.Behav- sights into the process by which investors form ex-
ioral investors think of money within mental ac- pectations about stock returns (Shefrin and Statman
counts and distinguish paper losses from "realized 1995b). An analysis of investor expectations might
losses." A stock with a paper loss might rise in price, well be the best route to understanding the equilib-
so the chance exists that the mental accountcontain- as
rium levels of expected returns because, everyone
ing the stock will break even, but a realized loss agrees,realized-return data, upon which virtually all
means kissing the hope of breaking even goodbye. current analyses are based, are very noisy. In com-
Behavioral investors are reluctant to realize losses, parison, the noise level in expectationaldata is low.
despite the tax advantagesof doing so, because the of For example, Fortunemagazine collects data on
pain of regret that comes with kissing hope goodbye. expectationsthrough surveys it conductsof a group
Gross (1982)described the reluctance of inves- of respondents who are commonly regarded as s0-
tors to realize lossesthis way: phisticated investors-executives, members of
Many clients,however,will not sell anything at a boards of directors, and financial analysts. Thou-
loss.Theydo not wantto give up thehopeofmaking sands of respondents are asked each year to rank
moneyon a particular investment, perhaps they companies on eight attributes, including quality of
wantto getevenbeforetheygetout. The"geteveni- management, quality of products and services,and
tis" disease probablywroughtmore destruction value as a long-term investment. The top three com-
on investment (p.
portfoliosthananythingelse. 150) panies, asjudged by the average quality scorein the
SheErinand I have analyzed transactionsin mutual survey published in the February 1993issue of For-
funds and stocks and found evidence against the tune,are Merck & Company, Rubbermaid, and Wal-
standard finance hypothesis that people engagein the Mart. The bottom three companies are Wang
tax arbitrage that Constantinides described (Shefrin Laboratories, Continental Airlines, and Glenfed.
and Statman 1985).Ignoring arbitrage opportunities Consider the relationship between the rating of
and leaving $100 (or much more) in the pocket of the a given company on quality of managementand on
IRS may not be rational, but it is hard for behavioral value as a long-term investment. Quality of manage-
investors to bring themselvesto realize losses. In
ment is an attribute of the company. contrast, value
as a long-term investment is an attribute of the stock tial properties to its parent population and (2)reflects
of the company. If respondeI\tsto the Fortune survey the salient features by which it is generated. In other
believe in market efficiency, they will conclude that words, an event A is judged more probable than an
the price of a stock fully reflects the quality of the event B when A appearsmore representative than B.
company. m efficient markets, the wonderful growth Kahneman and Tversky (1972)have supported the
opportunities of good companies are fully reflected hypothesis that subjectsjudge the probability of an
in the prices of their stocks, and therefore, the stocks event by its representativenesswith a series of ex-
offer no special value as a long-term investment. periments.
Similarly, the lousy growth opportunities of bad Consider this experiment (Kahneman and Tver-
companies are fully reflected in the prices of their sky 1982).Subjectswere presented with a brief per-
stocks. Neither stocks of good companies nor stocks sonality sketch of Linda: Linda is 31 yearsold, single,
of bad companiesare bargains in an efficient market. outspoken, and very bright. She majored in philoso-
If so, we should find a zero correlation between the phy. As a student, she was deeply concerned with
Fortune ratings on quality of management and the issues of discrimination and social justice and also
Fortune ratings on value as a long-term investment. participated in antinuclear demonstrations.
Now col"\Sider, contrast,what might be expected Subjectswere then asked which event is more
if the FortuI'\erespondeI\ts standard-financeinves- probable:
torswho properly incorporatethe knowledge reflected .Linda is a bank teller (T).
m findi11gson size and ratio of book value to market .Linda is a bank teller and is active in the
value (BVIMV) by Famaand French (1992) others.and feminist movement (T & F).
Shefrin and I have fOUI\dthat, in geI\eral,companies The description of Linda was constructed to be
thatFortuI'\erespondeI\ts highly by quality of man-
rate similar to or representative of the profile of an active
agemeI\t have high marketvalues of equity (large size) feminist and unrepresentative of that of a bank teller.
and low BVIMVs. Thesecharacteristics, course,ap-
of Now/the rules of probability state that the com-
ply to companieswhose stocks provide low returns, pound event T & F cannotbe more probable than the
accordi11g Fama and FreI'\ch.If respondeI\tsto the
to simple eventT. Yet, 87 percent of all subjectsjudged
FortuI'\e survey are aware of the Fama and French the probability of the compound event that Linda is
results, explicitly or implicitly, they should produce a a bank teller and is active in the feminist movement
negative correlation betweel\ the rating of a company ashigher than the probability of the simple event that
on quality of managementand the rating of the stock Linda is a bank teller.
of the company on value as a long-term mvestment. The outcome of this experiment is consistent
m fact,Shemn and I foUI\d neither the zero correlation with the hypothesis that subjects judge the prob-
between quality of managementand value as a long- ability of an event by its similarity or repre-
term investment, which would be expected if the sentativeness. Specifically/because a feminist
Fortunerespondentsbelieve stockprices are efficient, attitude seems more representativeof Linda than the
nor the negative correlation expected if the Fortune bank teller occupation, subjectsconcluded that Linda
respondents follow Fama and French. lI1Stead, we is more probably a bank teller and feminist than a
fOUI\da strong positive correlation. A regressionof bank teller.
value as a long-term investment on quality of man- In interviews following the experiment, Kahne-
agement produces not oIlly a positive coefficient man and Tversky asked 36 subjects to explain their
with a rare sigrlificant t-statistic, 43.95, but also an choices. More than two-thirds of subjects who se-
adjusted R2of 0.86.m other words, people as sophis- lected the compound event gave some version of a
ticated as the Fortune respondents think that good similarity or typicality argument as their reasonbut
stocksare the stocksof good companiesalthough the agreed, after some reflection, that the responsewas
evidence indicates that the opposite is true. wrong becauseeveryone who is both a bank teller
Why do people think that stocks of companies and a feminist must also be a bank teller. Only two
such as Merck, Rubbermaid, and Wal-Mart offer of the subjectsmaintained that the probability order
higher values as long-term investments than stocks need not agree with class inclusion, and only one
of companies such as Wang, Continental Airlines, claimed that he had misinterpreted the question.
and Gle11fed? Michael Solt and I have argued that In relation to good companies and good stocks,
mvestors tend to believe that good stocksare stocks Saltand I argue that investors overestimate the prob-
of good comparnes because they fall prey to the ability that the stock of a good company is a good
representativeness heuristic (Solt and Statman 1989). stock because they rely on the representativeness
A person who follows the representativeness heuristic. They overestimate the probability that a
heuristic evaluates the probability of an UI\certain good stock is stock of a good company because a
event by the degreeto which it (1)is similar in essen- good stock is similar to a good company.
The Fortune r~spo~den~ rate st~ks as if they like The Design and Marketing of Financial Products
stocks of companIes WIth high-quality management,
with high market values of equity, and with low In t~a~g students the basics of options, I draw
BV /MVs. Do they care about beta? No. Regression pro~t di~~ams, as.shown in Figure 1, of the four
results show that there is no statistically significant basIc POSItiOns: buymg a call, selling a call, buying a
relationship between value as a long-term invest- put, and selling a put. I ask the students, "Which
t db t positions do you like?" They like the idea of buying
men an. e a. ..calls and puts, but they hate the idea of selling (na-
TypICal ..c Fortune respondents are behavIoral m- ked) alls and pu. ts Th eyexp I am. that b uymgac . all .IS
vestors, mvestors who .believe that ~ood stocks are attractive because the position has a floor on losses
stocks of good companIes. Standard mvestors know but unlimited potential for gains. "The maximum
what Fama and Fren~ know, ~at g~od stocks are that I can lose is the premium," they say. Selling a
stocks of bad companIes. BehavIoral mvestors load (naked) call involves a ceiling on gains but unlimited
up on stocks of good companies. Standard investors potential for losses.
tilt their portfolios toward stocks of bad companies, Next, I show them a profit diagram of a covered-
but being fully rational, they are mindful of the nega- call option (shown in Figure 2), a position that com-
tive effect that concentration has on portfolio diver- bines buying a share of stock for, say, $21 and selling
sification. Thus, standard investors moderate the tilt a call option on the stock with an exercise price of $25
toward stocks of bad companies, and the force that for $1. My stud~nts like th~ idea of covered calls, but
they exert on stock prices may not therefore be they are surprised to realize that the shape of the
sufficient to counter fully the effect' of behavi~ral ~ro~t ~agr~ of the covered-call posi~on that they
h rt th
uili . b .
t like 15 Identical
to the shape of the selling a (naked)
Sh frin d I .f b h .al. put posItion that they hate. My students are hardly
e an see cons~ts ~ many e avlor mves- unique; the attraction of covered calls has been a
tors who hol~ portfolios tilted t~ward the stocks of puzzle to standard finance for years. But Shefrin and
good companIes, a few standard mvestors who hold I have attempted to explain that attraction (Shefrin
portfolios tilted toward stocks of bad companies, and and Statman 1993a).
an expected-returns equilibrium where stocks of bad Covered calls are promoted by investment advi-
companies-low market values of equity and high sors as positions that contain free lunches. Here is an
BV /MVs-have high returns. example from the Research Institute of America's
Profit Diagram for Call and Put Options
Figure 1. Buya Call
-.~_. Buy a Put
I "" :"
Sella Call Sella Put
.' .' 'I
Note:The solid horizontal line in each diagram is the stockprice at option expiration date. The tick marks
on this line indicate the point at which the strike price equals the stock price at expiration.
Figure2. ProfIt Diagramfor a Covered.caII dividends due you as the owner of the stock.
The third source of profit would be in the in-
creasein price of the shares,from what you
paid, to the agreed selling price.
By agreeing to sell at a higher price than you
bought, all you are giving up is the unknown, un-
knowable profit possibility above the agreed price.
In return, for relinquishing some of the profit poten-
Stock Price tial, you collect a handsome amount of cash that you
can immediately spend or reinvest, as you choose.(p.
Note the way Gross frames the cash flows into
three "sources of profit" rather than integrating the
Source: Meir Statman. three into an overall net cashflow. Of course, stand-
ard investors have no difficulty in integrating the
Personal Money Guide: cashflows, and they understand that covered calls
provide no free lunch. But not all investors can dis-
An investment strategy that can make you extra
entangle the cash flows from their frame, and cov-
money is writing calls on securities you already own.
...When you sell a call on a stock you own, you ered calls remain popular.
receive a premium. Think of these premiums as extra As Ross (1989) wrote, when standard finance
dividends. By careful selection of stocks and timing scholars are asked to explain the proliferation of
of writing calls, you have the opportunity to earn financial products and the features of their designs,
annual rates of returns of 11 percent to 19 percent: they tend to " fall back on old canards such as span-
regular dividends of 4 percent to 9 percent and pre- ning." Rossemphasizedthe role of marketing in the
mium "dividends" of 7 percent to 10 percent. world of financial products. SheErin and I (1993a)
And here is an example of the exasperated response have shown that an understanding of the behavior of
of standard finance: individuals and institutions explains the design of
Even for long-term investors who plan "never" to
covered calls, money market funds, and many other
sell their stocks,the premiums received from writing securities.
options against these stocks cannot be treated as
simply extra income to be added to the normal return
Behavioral Forces That Shape Financial
of the stocks, as some advertising in the options
industry seems to suggest. (Merton, Scholes, and Regulations
"Do you know what the concept of suitability means
Why do investors continue to ignore the good in the context of investments?" I ask financial econo-
advice of standard finance? One part of the answer is mists. Few know, and few investment textbooks
that behavioral investors frame the cash flows of mention suitability. In contrast, suitability regula-
covered calls into separate mental accounts rather tions are well known to securities brokers. Perhaps
than integrate them as standard finance suggests. financial economistswithin standard finance ignore
Consider the way Gross (1982) frames covered calls suitability regulations because they are not impor-
in his manual for brokers: tant, or perhaps they ignore them becausesuitability
JoeSalesman:You have told me that you have not is difficult to fit into standard finance.
beentoo pleased with the results of your Suitability regulations revolve around the re-
stock market investments. sponsibilities of brokers to their customers. Brokers
John Prospect:That's right. I am dissatisfied with
are required to ascertain that the securities they rec-
the return, or lack of it, on my stock portfolio.
JoeSalesman:Starting tomorrow, how would you ommend aresuitable for their customersbased on the
like to have three sources of profit every time customers' financial conditions and needs. Consider
you buy a common stock? the experienceof Charles Schwab& Company. Char-
John Prospect:Three profit sources?What are les Schwabis, of course,a discount. broker that pro-
they? vides no investment advice. An investor was trading
JoeSalesman:First, you could collect a lot of dol- options through Schwab and lost $500,000.Then,
lars-maybe hundreds, sometimes thou- claiming that those investments were unsuitable for
sands-for simply agreeing to sell your his financial condition and needs, he sued Schwab.
just-bought stock at a higher price than you
Schwab'sargument in its defensewas that it does not
paid. This agreementmoney is paid to you
right away, on the very next business day-
give advice; it merely trades what the investor wants
money that's yours to keep forever. Your sec- traded. The arbitration panel said that Schwab's ar-
ond source of profit could be the cash gument is irrelevant, the option trades were not suit-
able for that investor, and the fact that Schwab is a pay for IPOs. Should merit regulations be abolished
discount broker does not exempt it from suitability or, given the evidence on the returns IPas provide,
regulations. should the regulations be tightened?
The typical reaction of financial economistswhen Suitability and merit regulations are not the only
they are told about suitability regulations is that these tools designedto help behavioral investors cope with
regulations are senselessand should be abolished. their shortcomings. Shefrin and I have analyzed suit-
Suitability regulations prevent investors from using ability, merit, and such other regulations as those
their investor sovereigntyto choosethe securitiesthey pertaining to insider trading and mandatory disclo-
want and construct the portfolios that are, in their sure (Shefrinand Statman 1992,1993b).
judgments, optimal. The role of a theory is to explain
the evidence,however, not argue with it.
Suitability regulations make no sensein stand-
ard finance because,in standard finance, people are Standard finance is well built on the arbitrage princi-
assumed to be free of cognitive errors and problems ples of Miller and Modigliani, the portfolio construc-
of self-control. Suitability regulations are important, tion principles of Markowitz, and the CAPM of
however, for behavioral investors. Indeed, suitability Linmer and Sharpe. Standard finance does not do
regulations can be understood as tools that help be- well, however, as a descriptive theory of finance.
havioral investors control the effects of their cogni- Investors regularly overlook arbitrage opportunities,
tive errors and self-control problems. In that sense, fail to use Markowitz's principles in constructing
suitability regulations are analogous to "cooling-off" their portfolios, and fail to drive stock returns to
levels commensurate with the CAPM.
Considerthe door-to-door salesof vacuum clean- Peoplein standard finance are rational. They are
ers. By law, a customerhas three days after making a not confusedby frames, they are not affected by cog-
purchase, a cooling-off period, to cancelthe transac- nitive errors, they do not know the pain of regret, and
tion. The existenceof this law implies that people have they have no lapsesof self-control. People in behav-
realized that sometimes they get too "hot" for their ioral finance may not always be rational, but they are
own good; they need time to cool off, think clearly, always normal. Normal people are often confused by
and regain their self-control. So, through the legisla- frames, affected by cognitive errors, and know the
tive process, people created a law that helps them pain of regretand the difficulty of self-control. I argue
control their cognitive errors and imperfect self-con- that behavioral finance is built on a better model of
trol. The same argument applies to securities.People human behavior than standard finance and the better
understand that cognitive errors and imperfect self- model allows it to deal effectively with many puzzles
control interfere with good decisions.So, through the that plague standard finance, among them, the puz-
law, they appoint a broker or investment advisor to zles discussed here-investor preference for cash
do for them what parents do for children--say no to dividends, investor reluctance to realize losses, the
choices that parentsjudge irresponsible. determination of expectedreturns, the design of secu-
Or consider state merit, or blue-sky, regulations. rities, and the nature of financial regulations.
Under them, a bureaucrat in, for example, Sacra- Finance offers many other puzzles. Some are
mento decides whether a particular security can or small-for example, why the practice of dollar-cost
cannot be sold to residents of California. The ration- averaging persists despite its inconsistency with
ale behind merit regulations is that people are sus- standard finance (Statman 1995). Some are large-
ceptible to cognitive errors and, left to their own for example,why investors ignore Markowitz's rules
devices, will overpay for securities. As in the caseof of portfolio construction (Shefrin and Statman
suitability regulations, merit regulations are de- 1995b). Thesepuzzles might be solved within behav-
signed to protect investors from themselves,protec- ioral finance.
tion that makes no sensein standard finance. Financial professionals who understand behav-
Consider merit regulations in light of the evi- ioral finance will understand their own behavior and
dence on the returns from initial public offerings. improve their decisions.Institutional investors who
Mounting evideI:lceindicates that investors who buy understand behavioral finance will understand the
IPOs in the public market, on average,lose substan- beliefs and motives of their clients and will be better
tially. Left to their own devices,IPO investors over- at serving and educating them.
Question and Answer Session
Question: What is "quality of Question: With all theinforma- replacement for standard finance
management," how do we tion availableaboutthe benefits as a descriptive theory. The re-
measure or quantify it? of indexing-costs are low and turn anomalies are the pebbles in
managers havedifficulty outper- the shoe that make one say,
Statman: Quality of manage- formingthe indexes-why aren't "Enough! Standard finance does
ment is the rating of quality of morepeopleindexing? not work." When standard theo-
management by respondentsto ries of portfolio selectionare in-
Fortune's survey of companies.Re- Statman: Indexing does not cor- consistent with the evidence and
spondents give each company a respond to investors' intuition when market forces are inconsis-
score on quality of management about the way the market works.
tent with the predictions of the
ranging from zero (absolutely aw- I ask my students, "When you
CAPM, the wise move is to go
ful) to ten (glorious). The correla- buy a stock becauseyou are confi-
tions cited in the presentation are dent that it is a bargain, who do back to an examination of the fi-
based on the averagesof those you think is the idiot who is on nancial decisions of individuals.
rankings from all the Fortunere- the other end of the transaction?/l Moreover, the activities of in-
spondents. We do not know the Most have never thought about dividuals and institutions are a le-
respondents' thought processes in this question. Most people do not gitimate concern of the field of
assigning the ratings. think about the stock market as a finance even if they do not affect
zero-sum game relative to index prices. When corporations fail to
Question: Did you examine the funds. They do not consider the deploy their assetsefficiently,
relationship between past stock likelihood that the trader on the welfare declines.Agency theory
performance and managementrat- other side of the trade might be focuseson the issues that pertain
ings from the Fortunesurvey? an insider and that they, in fact, to welfare lossesand mechanisms
are the patsy. for alleviating such losses(seeJen-
Statman: Yes, and the answer is sen and Meckling 1976).Welfare
in a paper that Roger Clarke and I Question: Some of the findings lossesalso exist when individuals
wrote (Clarke and Stabnan1994). of decision theory suggestthat in- fail to construct efficient portfo-
One of the characteristics of high- dividuals overpay for volatility / lios; a description of such losses
quality companies is that their whereas your researchsuggests and mechanismsfor the allevia-
past stock returns are high. that individuals overpay for sta-
tion of such lossesare a concern
bility / or good companies. How
of finance practitioners and
do we reconcile theseviews?
Question: As a matter of com- should be a concern of finance
munication, can we educateour- academics.
selvesand our clients to look at Stabnan: People frame their As behavioral finance devel-
portfolios rather than segments? money into those different pock-
ops, we ought to keep in mind
If so, how? ets. So,there is no unified attitude
that we need theory that contains
toward risk. Many people who
buy insurance also buy lottery testablehypotheses, not stories. I
Statrnan: It is possible to edu- take delight when somebody
tickets. Are they risk averse or
cate people, but we need more finds evidence contrary to hy-
than education. I begin my talk risk seeking?Investors divide
their money into "safe" money pothesesof behavioral finance. At
about portfolios in my invest-
and "risky" money (She£rin and least nobody can say that our the-
ments class by telling students
Statrnan1995a). ory is a just-so theory that cannot
that their intuition is likely to mis-
be refuted by evidence.
lead them. What is really needed
Question: A so-called new fi- Moreover, explaining the ex-
are structures that prevent us
from acting on wrong intuition- nance is driven heavily by market isting anomalies is not enough.
for example, a work sheetwith inefficiency. Where does behav- Behavioral finance will be tested
boxes that must be filled in-a ioral finance fit in this approach- in its ability to explain phenom-
framework that forcesus to con- as a subsetor as the keystone? ena that are not even recognized
sider factors that, acting on intui- today as anomalous within stand-
tion alone, we are likely to miss. Statman: Behavioral finance is a ard finance.