Meir Statman

Behavioral Portfolio Theory

We develop a positive behavioral portfolio theory (BPT) and explore its implications for portfolio constrution and security design. The optimal portfolios of BPT investors resemble combinations of bonds and lotterly tickets consistent with Friedman and Savages (1948) observation. We compare the BPT efficient frontier with the mean-variance efficient frontier and show that, in general, the two frontiers do not coincide. Optimal BPT portfolios are also different from optimal CAPM portfolios. In particular, the CAPM two-fund separation does not hold in BPT. We present BPT in a single mental account version (BPT-SA) and a multiple mental account version (BPT-SA). BPT-SA investors integrate their portfolios into a single mental account, while BPT-SA investors segregate their portfolios into several mental accounts. BPT-SA portfolios resemble layered pyramids, where layers are associated with aspirations. We explore a two-layer portfolio where the low aspiration layer is designed to avoid poverth while the high aspiration layer is designed for a shot at riches.

Explaining investor preference for cash dividends

Abstract The well-known tendency of investors to favor cash dividends emerges quite naturally in two new theories of choice behavior [the theory of self-control due to Thaler and Shefrin (1981), and the version of prospect theory set out by Kahneman and Tversky (1979)]. Although our treatment is novel when viewed from the perspective of standard financial theory, it provides explanations for a phenomenon that has long been described as perplexing.

Behavioral Capital Asset Pricing Theory

This paper develops a capital asset pricing theory in a market where noise traders interact with information traders. Noise traders are traders who commit cognitive errors while information traders are free of cognitive errors. The theory includes the determination of the mean-variance efficient frontier, the return on the market portfolio, the term structure, and option prices. The paper derives a necessary and sufficient condition for the existence of price efficiency in the presence of noise traders and analyzes the effects of noise traders on price efficiency, volatility, return anomalies, volume, and noise trader survival.

Socially Responsible Indexes

Socially responsible investment (SRI) indexes vary in composition and social responsibility scores, but have higher mean social scores than the S&P 500 index. Socially responsible indexes differ in the emphasis they place on social characteristics. The DS 400 index is the strongest among all indexes on the environment, for example, while the Calvert Index is the strongest on corporate governance. The DS 400 index returned more than the S&P 500 index over May 1990-April 2004, but not in every subperiod. In general, SRI indexes did better than the S&P 500 index during the boom of the late 1990s but lagged it during the bust of the early 2000s.

Portfolio Optimization with Mental Accounts

We integrate appealing features of Markowitz’s mean-variance portfolio theory (MVT) and Shefrin and Statman’s behavioral portfolio theory (BPT) into a new mental accounting (MA) framework. Features of the MA framework include an MA structure of portfolios, a definition of risk as the probability of failing to reach the threshold level in each mental account, and attitudes toward risk that vary by account. We demonstrate a mathematical equivalence between MVT, MA, and risk management using value at risk (VaR). The aggregate allocation across MA subportfolios is mean-variance efficient with short selling. Short-selling constraints on mental accounts impose very minor reductions in certainty equivalents, only if binding for the aggregate portfolio, offsetting utility losses from errors in specifying risk-aversion coefficients in MVT applications. These generalizations of MVT and BPT via a unified MA framework result in a fruitful connection between investor consumption goals and portfolio production.

Investor Sentiment and Stock Returns

The author investigates the predictive power of investment newsletters and concludes that writers of investment newsletters do not seem to have any statistically significant ability, as a group, to forecast stock returns. Using statistical tools, the article shows that there is no discernable relationship between the forecasts made by newsletter writers as a group and stock market returns over four, twenty-six, or even fifty-two weeks. Statman then considers the questions of what makes forecasters turn bullish or bearish. He finds that they typically tend to “follow the tape” in the short term, but concludes that strong medium – to longer-term returns will lead forecasters both to become more bullish and to start anticipating some correction. Statman finally looks into the impact of more volatility on the propensity of forecasters to become more or less bullish, and concludes that high volatility does scare newsletter writers into bearishness.

Applying Behavioral Finance to Capital Budgeting: Project Terminations

The net present value approach to project termination has been investigated by Bonini [1], Dyl and Long [3], Gaumnitz and Emery [5], Howe and McCabe [7], and Robichek and Van Home [17, 18]. While these investigations vary in many aspects, they share the conclusion that sunk costs should be ignored and that projects should be terminated when the expected present value of cash flows, given that the project is terminated oday, is greater than the expected present value of cas flows given that the project is continued for at l ast one additional period. Do managers follow this advice? We suggest that managers tend to become entrapped into losing projects and throw good money after bad as they attempt to rescue them. Termination decisions are difficult even when they are wise. Consider, for example, the report by Russell [19] on the development of an eight-inch floppy disk drive (half-height, double-sided, double density, one megabite capacity) by the Shugart Corporation. The disk-drive project was initially seen as a profitable project by Shugart Corporation, a company that has already established itself as a leader in disk drives. Shugart started the project in 1980, and supported it generously. The project was abandoned in 1983, after severe time and cost overruns and long after disk drives by competitors had been designed into computThe authors wish to thank Melanie Austin, Keith Brown, George Pinches, Robert Taggart, James Van Home and two anonymous reviewers for comments on an earlier draft. Meir Statman acknowledges support from a Batterymarch Fellowship.

Investment Advice from Mutual Fund Companies

Mutual fund companies now offer a significant amount of investment guidance for clients. The authors report that most companies consider risk and return characteristics when giving advice, but the advice does not conform to the Markowitz mean–variance framework. Hence, most individual investors’ portfolios are not on the efficient frontier. Fortunately, the annual return deficiency caused by this deviation is small.

Cognitive Biases in Market Forecasts

Will the DJIA soar to 36,000 or plummet to 3,600? The desire to know the future is so strong that it blinds us to the fallibility of forecasts. The authors find that P/E ratios and dividend yields provide no help in forecasting one or two–year stock returns, and even ten–year forecasts are far from reliable. They trace the belief that P/E ratios and dividend yields provide reliable forecasts of returns to cognitive errors and discuss statistical and organizational remedies.

Fixed Rate or Index-Linked Mortgages from the Borrower's Point of View: A Note

When will borrowers choose fixed rate mortgages and when will they prefer index-linked mortgages? Baesel and Biger (BB) [1] proposed a model that answers this question. According to the BB model, a borrowers preference depends on the difference in interest rates between the fixed and index-linked mortgages, and on the covariance between the borrowers labor income and the rate of inflation. The purpose of this note is to propose a more complete model of borrower preferences. The novelty of the model lies in the inclusion of the value of the house (net of mortgage obligation) in the terminal wealth of the borrower. This inclusion leads to differences between this model and the BB model in the identification of the cases where borrowers will prefer fixed or index-linked mortgages.