Why you're not a rational investor

We like to think we make investment decisions based on facts. But we often end up paying to express our beliefs, to acquire status, or to seem smarter than our peers.

By Meir Statman, Fortune

(Fortune Magazine) -- Investors who abhor smoking or environmental degradation are regularly told by financial advisors that they should choose stocks that yield the highest returns, including stocks of companies that produce tobacco or pollute the environment, and then donate their profits to campaigns for the causes they support.

That suggestion sounds rational. But it is fundamentally flawed. In fact, it's akin to suggesting to an Orthodox Jew that he forgo kosher food for cheaper nonkosher food and donate the savings to his synagogue.

The advice is symptomatic of a more general tendency to separate an investment's "utilitarian" characteristics of risk and expected returns from its "expressive" characteristics -- those that convey to us and to others our values, tastes, wealth, and social class.

Almost all products combine utilitarian and expressive characteristics. The utilitarian characteristics of a car include gas mileage, reliability, and safety, while its expressive characteristics include style, status, and social responsibility.

Both a Hummer and a Prius would get you from home to work and back. But a Hummer expresses dominance, while a Prius expresses environmental responsibility. There is no way to separate the utilitarian characteristics of a Hummer or Prius from its expressive characteristics.

The same is true for investments. For example, hedge fund investors may or may not attain high returns from their investments, but they surely attain high status. Mention your hedge funds, and we instantly know that your income is high and so is your wealth. We might even think that you are a smart, sophisticated investor. Mention your shares of the AWM Fine Wine fund, and we might think that your tastes are refined. (Or we might think that you are a wine snob.)

Stocks are like cars -- some have more cachet than others even if they are unreliable at delivering returns. Studying rankings in the Fortune surveys of companies, my colleagues and I found that stocks of the more admired companies delivered lower returns than stocks of the less admired companies.

Evidently stocks of admired companies are like a Mercedes, long on cachet but short on reliability, while stocks of less admired companies are like Toyota cars, delivering returns without style. Financial services companies understand the importance of expressive characteristics. Exchange-traded funds (ETFs) are advertised to young investors not only as smart investments but also as cool ones.

"This is not your father's mutual fund," they seem to say. Private banking is advertised to older investors with a chauffeured vintage Rolls-Royce and the tag line, "Once you've earned exclusive service, there's no turning back."

This distinction also helps explain why most mutual fund money still goes into active funds, when index funds have long delivered better returns. Ignorance is one part of the answer. Education by Jack Bogle and countless professors did not reach all investors or failed to persuade them. Hope, another expressive characteristic, is also part of the answer. Active mutual funds, like lottery tickets, let us dream about vast riches. Hope is not extinguished when one active mutual fund or lottery ticket disappoints. Many more are available.

My research has shown that some investors understand the tradeoff between utilitarian returns and expressive social responsibility, status, or hope, and are willing to pay for what they get. A socially responsible investor told me that poor performance of a socially responsible mutual fund when she had little money compelled her to switch to a conventional fund. But now her resources are substantial, and her preferences are different.

"I consider it a luxury that I now have the ability to invest more in line with my values," she said.

There is nothing wrong with giving up money for cachet. But it is sad when we invest in hedge funds or private equity or "name brand" stocks in hope of extra returns without recognizing that we are paying for cachet. I'm waiting for a business magazine that will offer us a list of the benefits of each investment option.

An active mutual fund might be listed as providing 8% of expected returns, plus 2% worth of hope; a hedge fund, 6% of expected returns, 2% of hope, and 2% of cachet; and an index fund, 10% of expected returns with neither hope nor cachet.

Meir Statman is the Glenn Klimek Professor of Finance at Santa Clara University. He studies investor behavior and how it affects markets.  Top of page