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Published: May 31, 2017 7 min read
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Ask retirement investors what they want from their portfolios and they are likely to say they are looking to make money to sustain them in the future. The view you get in standard finance textbooks is also all about dollars and cents: Investors are rational creatures making informed choices by weighing potential future returns against risk.

That's very different from how other researchers see us: Over the past three decades, the burgeoning field of behavioral finance has explored the many cognitive and emotional errors that lead people into foolish behaviors and poorly performing portfolios. For example, overconfidence results in frequent trading, whose costs harm returns. The costly duo of unrealistic hope and excessive fear leads investors to pile into stocks just before market peaks and dump their stocks in market crashes.

The reality: Normal investors, people like you and me, are neither purely rational nor bumblingly irrational. We have some nonfinancial wants that drive what we do with our portfolios. While that may seem bad, it's really okay—within reason.

The New Message of Behavioral Finance

In the current second generation of behavioral finance, we are exploring people's nonfinancial desires and acknowledging that they have a legitimate place in our money matters. These wants can include the desire to invest in things that we are comfortable with and that are in line with our principles of social responsibility. We may also want to impress other people or have fun picking stocks.

A portfolio that satisfies such desires can look very different from one constructed solely to deliver the highest expected return for the ups and downs we are willing to stomach. Consider an analogy between investment portfolios and the "food portfolios" we know as diets.

In 1939 economist George Stigler evaluated 77 food items, from wheat flour to sirloin steaks to strawberry preserves, and found that the lowest-cost nutritionally sound diet consisted of only five foods. The full-year diet of a moderately active man weighing 154 pounds included 370 pounds of wheat flour, 57 cans of evaporated milk, 111 pounds of cabbage, 23 pounds of spinach, and 285 pounds of dried navy beans. The annual cost at the time: $39.93.

But that's not how normal people want to eat, of course. Stigler then looked at what dietitians suggested as a healthy low-cost choice. That diet would have cost $100 in 1939, more than double the figure for Stigler's food list. The dietitians were trying not just to meet numerical targets for nutrition at a decent price, but also to satisfy wants including palatability and variety. Hello, meat and sugar.

A Palatable Portfolio

Similarly, in managing their retirement investments, there are many ways people may want to modify the mix of securities they own to make it more palatable, even if they potentially give up some return.

For instance, a standard analysis of returns and risk might call for putting half your stock dollars into foreign shares, since they represent about half the total value of stocks around the world. To some investors, that mix is unpatriotic; others may simply feel uncomfortable investing so many dollars in stocks whose names they may not know. This preference to overweight our own country's stocks is called "home bias," which sounds negative, but it can more neutrally be seen as a nonfinancial want.

In another variation, some investors want to exclude certain companies—such as those associated with nuclear energy or weapons or tobacco or contraceptives—to invest in a "socially responsible" way. A survey by the Spectrem Group found that 37% of investors with a net worth of $1 million to $5 million consider social responsibility when they pick securities.

And then there are hedge funds—complex, high-fee investments available only to affluent individuals and institutions. In many recent periods, their performance has trailed that of basic, bland choices like stock index funds. But hedge funds convey high status in some social circles, and some investors value being able to say they own them.

The Bottom Line

In making financial choices, we need to begin by knowing our wants and the tradeoffs among them. We also must watch out for common behavioral errors and look for ways to balance financial and nonfinancial desires.

For instance, let's say you are reluctant to invest half your stock money in foreign stocks even though there is a rational case to do so. Maybe you want to skip overseas shares entirely. Instead, how about investing one-quarter of your stock money in overseas stocks? This is better than giving up all the risk-reducing benefits of global diversification. Even financial consultants working with sophisticated investors like pension funds will often tweak the portfolios they recommend to stay within conventional desires to invest heavily in U.S. stocks.

You'll need to hunt out ways you may be fooling yourself. People are usually reluctant to admit they are status seeking. Acknowledge that a hedge fund may be enticing as a badge of high status, but also take a cold look at the fees.

Similarly, if you are trading individual stocks, are you being honest with yourself about the reason? I encountered one investor who never sold securities on which he had lost money. In measuring his investing prowess, he counted only his realized gain, maintaining the illusion that he was beating the market.

You might ask a trusted friend to conduct an honest audit of your portfolio's gains and losses. If you enjoy playing the market despite losses, as others enjoy playing video games, allocate only 5% or less to "play money" you can afford to lose without damage to your retirement security.

Meir Statman is the Glenn Klimek professor of finance at Santa Clara University's Leavey School of Business. This article is adapted from his new book, Finance for Normal People: How Investors and Markets Behave (Oxford University Press, 2017).

You can purchase Finance for Normal People: How Investors and Markets Behave, here.

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