What Investors Really Want: Book Excerpt
Excerpted from WHAT INVESTORS REALLY WANT by Meir Statman, reprinted with permission from McGraw-Hill Professional, copyright 2011.
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By Meir Statman
Today's Pursuits of Profits Higher than Risks
Lessons from a century ago need repeating because we fail to learn. Almosthalf a million Italian retirees bought Argentine bonds in the 1990s becausethey offered higher interest rates than Italian bonds. The word
default
became an Italian word in 2001 when Argentina defaulted on its bonds.In 2005 Nestor Kirchner, Argentina's president at the time, offered to paybondholders less than a third of their investment. When Rodrigo de Ratoof the International Monetary Fund called on Argentina to be respectfulto bondholders, Kirchner mocked him, "It's pathetic to listen to themsometimes." "Enter now," said Kirchner to the bondholders, "or it will beyour problem."
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In 2010 Cristina Fernandez de Kirchner, who succeededher husband as Argentina's president, offered bondholders a deal no betterthan the one offered by her husband five years before. "At this point theycould accept anything," said Lucio Golino, who works with a consumerprotection group in Rome. "A lot of people are tired and have had enough."But Egidio Rolich, who bought Argentine bonds with the proceeds from thesale of an apartment and his wife's severance pay, was not ready to acceptArgentina's offer. "Investors were shafted the first time with the default,"he said, "the second time with the 2005 swap and this time is going to bethe third."
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The desire for returns higher than risks also fuels the Nigerian 419 scamswe know from emails of the kind I received from Mrs. Catharina KittySies from the Netherlands, addressed to "Dearly beloved in Christ." Mrs.Sies was married to the late James Davis "of blessed memory" who workedwith the South African Embassy before he died. While at the embassy, Mr.Davis deposited $25 million with a company in Europe. Now Mrs. Sies isill with cancer and fibroid problems and her doctor told her that she has nomore than three months to live. "Having known my condition," wrote Mrs.Sies, "I decided to donate this find to either a charity organization, devotedChristian individual, or God-fearing person who will utilize this moneythe way I am going to give instruction with all sincerity to fund churches,orphanages homes, widows and also propagating the word of God." Mrs.Sies promised to send me the $25 million "luggage" as soon as she receivesmy reply.
Nigerian 419 scams seem easy to detect yet prove irresistible to thoselooking for returns higher than risks. The United States Secret Service estimatesthat such scams cost Americans more than $100 million each year.Yet Americans are not alone as scam targets. Australians make good targetsas well, according to a report by the Australian Securities InvestmentsCommission (ASIC). Australians are targeted, wrote ASIC, because theirinterest in investments is not matched by knowledge. Men are by far moregullible than women, accounting for more than nine out of 10 scamvictims.
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Banks sold $7 billion of reverse convertibles in 2008, promising returnshigher than risks and collecting fees in the process. Reverse convertiblesare bonds linked to stocks such as
Apple
(AAPL) - Get Report
and
Johnson & Johnson
(JNJ) - Get Report
. Investorswere promised high interest rates during the life of the bonds in addition totheir invested money when the bonds mature. Yet if the prices of the stocksto which the bonds are linked fall, investors get the stocks rather than theirinvested money. The high interest rates of reverse convertibles were enticing,but not all investors were aware of their risks. Lawrence Batlan, an85-year-old retired radiologist, invested $400,000 in reverse convertibleslinked to stocks such as
Yahoo!
(YHOO)
and
SanDisk
(SNDK)
. He lost $75,000 of it whenstock prices declined. "I had no idea this could happen," said Dr. Batlan. "Ihave no desire to own Yahoo! stock or the others."
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The "accumulator" was also an investment that was too good to be true,but this one was offered mainly to investors in Hong Kong. Accumulatorsobliged investors to buy shares of a stock at a fixed price. Investors profitedif the price of the shares increased but lost if the price decreased. Yet theprofit potential of investors was limited by a condition mandating that theysell their shares back to the issuer if their price increases to a specified level.The year 2008 was bad for investors in accumulators as stock prices declinedand investors nicknamed accumulators "I kill you later." The fundamentalflaw ... is something that I learned from my grandmother," said KathrynMatthews, an investment professional. "You get nothing for free."
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The trading records of thousands of investors at an American brokerreveal that the returns of the heaviest-trading beat-the-market investorstrailed those of index investors by more than seven percentage points eachyear on average, while the lightest trading investors trailed by only one quarterof a percentage point.
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The trading records of thousands of investorsat a Swedish broker reveal that, on average, the losses of heavy tradersamounted to almost 4% of their total financial wealth each year.
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Beat-the-market investors trail further behind index investors becausethey tend to buy high and sell low, reversing the investment maxim of buyinglow and selling high. Investors who switched stocks frequently in 19major international stock markets trailed index investors by an average1.5 percentage points each year.
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Investors who switched mutual fundsfrequently trailed buy-and-hold mutual fund investors by less than onepercentage point if they switched among mutual funds dedicated to stocksof large-value companies, but the lag increased to more than three percentagepoints if they switched among mutual funds dedicated to stocksof small-growth companies, and to an astonishing 13 percentage points ifthey switched among mutual funds dedicated to stocks of technology companies.
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Switching-hedge-fund investors did no better than switching mutual-fund investors. Hedge fund investors who switched among fundstrailed those who bought and held hedge funds by approximately four percentagepoints each year. Those who switched among "star" funds with thehighest returns trailed by approximately nine percentage points.
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BEAT-THE-MARKET INVESTORS EXPLAINED
Why don't beat-the-market investors abandon their game and join indexinvestors? One part of the answer is easy. While average beat-the-marketinvestors cannot beat the market, some beat-the-market investors areabove average. Professional investors, such as mutual fund and hedge fundmanagers, regularly beat the market. Stocks bought by beat-the-marketmutual fund managers had higher returns than stocks sold by them.
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Andhedge fund managers are famous for the billion-dollar paychecks they earnby beating the market. But investors in beat-the-market mutual funds trailinvestors in index funds because the costs of beat-the-market mutual fundsdetract from the returns passed on to investors more than managers addto them.
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Hedge funds are riskier than investors believe and the returnsthey pass on to investors are lower than investors believe.
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Tom Perkins, awealthy venture capitalist, tells about Harry, one of his investors, who askedhim how Perkins can live with the risk of his investments. "Well, Harry,"laughed Perkins, "it's your money!"
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Military service is mandatory in Finland so that nearly every Finnishmale of draft age undergoes extensive intelligence tests. Intelligence promotesinvestment success. Finns who score highly on intelligence at draftage are better at picking stocks in the following years than their less intelligentbrethren.
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Germans who score highly on cognitive skills resist cognitiveerrors better than their less intelligent brethren.
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Highly intelligentinvestors might be able to beat the market, but their success is far from assuredbecause intelligent investors are not always wise. Harvard staff membersare intelligent and so are Harvard undergraduate students with SATscores in the 99th percentile and Wharton MBA students with SAT scoresat the 98th percentile.
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Staff and students received information about pastperformance and fees of index funds that track the S&P 500 Index. But theinformation about the funds varied by the dates when the funds were establishedand the dates when the funds' prospectuses were published.
Wise investors faced with a choice among index funds following theS&P 500 Index choose the index fund with the lowest fees since these indexfunds are otherwise as identical as identical cereal boxes. But nine out of10 staff and college students chose index funds with higher fees and so dideight out of 10 MBA students. Staff and students chased returns instead,choosing funds with the highest historical returns, apparently assumingthat these offer returns higher than risks. Staff ranked fees as the fifth mostimportant factor in their choice of funds, out of 11 factors, and studentsranked it eighth. Staff chose funds whose annual fees exceeded theminimum fee by more than two percentage points on average, and studentschose funds whose fees exceeded the minimum fee by more than one percentagepoint.
This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.