Normal Investors, Then and Now

by Meir Statman Glenn Klimek Professor of Finance Santa Clara University Leavey School of Business Santa Clara, CA 95053 mstatman@scu.edu

September 2004

Normal Investors, Then and Now Abstract The 1960 issue of the Financial Analysts Journal contains a pair of remarkable articles. In the first, Edward F. Renshaw and Paul J. Feldstein proposed the creation of what we know today as index funds. In the second, John B. Armstrong argued against index funds. John B. Armstrong is a pen-name of John C. Bogle, the founder of Vanguard who introduced the first of many index mutual funds in 1976 and remains their foremost advocate. Bogle reflected on index funds and changed his mind. The 60th anniversary of the Financial Analysts Journal is an opportunity for all of us to reflect on past changes of mind and perhaps contemplate future ones. The year 1960 was in the midst of an extraordinary time when academics and practitioners of finance were changing their minds, switching from a framework where investors are normal to one where investors are rational. Normal investors are affected by cognitive biases and emotions, while rational investors are not. Rational investors care only about the risk and expected return of their overall portfolios, while normal investors care about more than that. The portrait of investors as rational is the first foundation block of standard finance. Other foundation blocks are mean-variance portfolio theory, Capital Asset Pricing Model (CAPM), and market efficiency. I describe normal investors as they were portrayed in the Financial Analysts Journal and other finance journals before standard finance was introduced and as they emerged more recently in behavioral finance.

Normal Investors, Then and Now The 1960 issue of the Financial Analysts Journal contains a pair of remarkable articles. In the first, “The case for an unmanaged investment company,” Edward F. Renshaw and Paul J. Feldstein compared the returns of mutual funds to those of the DJIA and found that only 11 of 89 diversified common stock and balanced funds had returns higher than those of the DJIA. This and similar evidence led them to propose the creation of what we know today as an index fund, “a new investment institution, what we have chosen to call an ‘unmanaged investment company’ – in other words a company dedicated to the task of following a representative average.” (p. 43) In the second, “The case for mutual fund management,” John B. Armstrong argued against the idea of index funds “[f]irst and foremost,” because it “ignores the fact…that the Dow Jones Industrial Average has not in fact matched common stock mutual funds with comparable volatility in performance results.” (p. 37) “John B. Armstrong is a pen-name of a man who has spent many years in the security field and in the study and analysis of mutual funds. A graduate of Princeton University, his A.B. thesis was entitled ‘Economic Role of the Investment Company.’” (p. 33). The real name of John B. Armstrong is John C. Bogle, the founder of Vanguard who introduced the first of many index mutual funds in 1976 and remains their foremost advocate. Bogle reflected on index funds and changed his mind. The 60th anniversary of the Financial Analysts Journal is an opportunity for all of us to reflect on past changes of mind and perhaps contemplate future ones.

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The year 1960 was in the midst of an extraordinary time when academics and practitioners of finance were changing their minds, switching from a framework where investors are normal to one where investors are rational. Normal investors are affected by cognitive biases and emotions, while rational investors are not. Rational investors care only about the risk and expected return of their overall portfolios, while normal investors care about more than that. The portrait of investors as rational is the first foundation block of standard finance. Other foundation blocks are mean-variance portfolio theory, Capital Asset Pricing Model (CAPM), and market efficiency. I describe normal investors as they were portrayed in the Financial Analysts Journal and other finance journals before standard finance was introduced and as they emerged more recently in behavioral finance. Rational investors Miller and Modigliani described investors as rational in their 1961 article on dividend policy. Rational investors “always prefer more wealth to less and are indifferent as to whether a given increment to their wealth takes the form of cash payments or an increase in the market value of their holdings of shares.” (p. 412). Rational investors are indifferent to dividend policy because an increment to their wealth in the form of dividends is different only in form, not in substance, from an increment in wealth in the form of capital gains. Miller and Modigliani wrote that the indifference of rational investors to dividend policy is “’obvious, once you think of it.’…Obvious as the proposition may be, however, one finds few references to it in the extensive literature on the problem.” (p.414)

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Form, label or packaging do not affect stock prices, according to Miller and Modigliani, because of the power of arbitrage. If the value of a company that pays generous dividends is higher than the value of an otherwise identical company that pays no dividends, rational investors would engage in arbitrage, selling shares of the first and buying shares of the second until the values of the two companies converge. Indeed, arbitrage would do its work even if most investors are normal, affected by form, label or packaging, as long as there are some rational investors who engage in arbitrage. Recognition of the power of arbitrage led Miller to argue not only that security prices are affected only by the “real considerations,” of the earning power of the firm’s assets and its investment policy, but also that exploration of considerations other than “real considerations” is a harmful distraction. As Miller wrote later, in 1986, responding to Shefrin and Statman’s (1984) behavioral approach to the dividend question, “Behind each holding may be a story of family business, family quarrels, legacies received, divorce settlements, and a host of other considerations … That we abstract from all these stories in building our models is not because the stories are uninteresting but because they may be too interesting and thereby distract us from pervasive market forces that should be our principal concern.” (p. S467). The preference of rational investors for more over less and the power of arbitrage also underlie the efficient market hypothesis, the second foundation block of standard finance. An efficient market is a market where prices are always equal to fundamental values. Any deviation of price from value invites arbitrage by rational investors who drive price toward value.

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The labels of weak, semi-strong and strong forms of the market efficiency hypothesis would come only later, but Alfred Cowles noted in 1960 that the power of arbitrage would make markets efficient in the weak form, where prices follow ‘random walk.’ Cowles wrote that “if the persistence in stock price movements were sufficient to provide capital gains appreciably in excess of brokerage costs, professional traders would presumably be aware of this situation and through their market operations would inadvertently wipe out the persistence in price movements from which they were attempting to profit.” (p. 915) Cowles wrote his first article on random walk in 1933 and Brown, Goetzmann and Kumar (1998) argued that the article “is a watershed study that led to the random walk hypothesis, and thus played a key role in the development of the efficient market theory. (p. 1331). But the real push for the random walk hypothesis had to wait until Harry Roberts’ 1959 article and especially until Eugene Fama’s 1965 articles. Neither Roberts nor Fama cited Cowles 1933 article. Roberts wrote that many financial analysts “believe that the history of the market itself contains ‘patterns’ that give clues to the future, if only these patterns can be properly understood.” (p. 1) He went on to examine the patterns of stock prices and found that they are no more than “statistical artifacts” that would arise by chance. The title of Fama’s Financial Analysts Journal article was “Random Walks in Stock Market Prices.” Random walk, he wrote, implies that a “simple policy of buying and holding a security will be as good as any more complicated mechanical procedure for timing purchases and sales.” (p. 56)

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The weak form of the market efficiency hypothesis states that investors cannot gain abnormal returns through technical analysis, where they uncover patterns in stock prices. The semi-strong form states that investors can neither gain abnormal returns through fundamental analysis, where they uncover insights in public information. Tests of the semi-strong hypothesis often require adjustment for differences in risk among stocks and such tests did not come to full function until Sharpe introduced the Capital Asset Pricing Model (CAPM) where beta measures risk. In turn, the CAPM had to await Markowitz’s mean-variance portfolio theory. “Diversification of investments was well-established practice long before I published my 1952 paper on portfolio selection…,” wrote Markowitz in his 1999 review, “The early history of portfolio theory: 1600-1960,” in the Financial Analysts Journal. “For example, A. Wiesenberger’s annual reports in Investment Companies prior to 1952 (beginning 1941) showed that these firms held large numbers of securities… What was lacking prior to 1952 was an adequate theory of investment that covered the effects of diversification when risks are correlated, distinguished between efficient and inefficient portfolios, and analyzed risk-return trade-offs on the portfolios as a whole.” (p. 5) Markowitz provided that in his mean-variance portfolio theory. While Markowitz published his first article on mean-variance portfolio theory in 1952, he wrote in his 1999 review that the 1952 article “should be considered only as a historical document—“ (p. 6). It is the 1959 book that represents his views. Investors in mean-variance portfolio are the rational investors of Miller and Modigliani. They care only about the expected returns and risk of their overall portfolios. So mean-variance investors are never reluctant to realize losses on individual stocks when tax savings add

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to their wealth. And mean-variance investors do not care about characteristics, such as the dividend yield of stocks or the social responsibility of their companies, unless they affect the risk and expected returns of overall portfolios. Markowitz’s mean-variance portfolio theory is the third foundation block of standard finance and Sharpe’s Capital Asset Pricing Model (CAPM) is the fourth. Markowitz described the day when Sharpe started his CAPM work. “One day in 1960, having said what I had to say about portfolio theory in my 1959 book, I was sitting in my office … working on something quite different, when a young man presented himself at my door, introduced himself as Bill Sharpe, and said that he was … looking for a thesis topic… We talked about the need for models of covariance. This conversation started Sharpe out on the first of his (ultimately many) lines of research, which resulted in [the CAPM].” (p. 14) While Markowitz’s mean-variance portfolio theory is prescriptive, recommending the mean-variance algorithm to investors who care only about risk and expected return of their overall portfolios, the CAPM is descriptive, describing investors who do so. In 1968, Michael Jensen introduced “Jensen’s alpha,” based on the CAPM and offered evidence supporting the semi-strong hypothesis of market efficiency. He found that the risk-adjusted returns of mutual funds were lower, on average, than the return of the stock market as a whole. The foundation blocks of standard finance were now in place, supporting one another. Investors are rational, prices are efficient, risk is measured by beta and investors form portfolios by the rules of mean-variance portfolio theory.

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Normal investors Investors were normal before Miller and Modigliani described them as rational, and they remain normal today. In 1957, before the introduction of standard finance, Howard Snyder taught normal investors “how to take a loss and like it” in a Financial Analysts Journal article by that name. “There is no loss without collateral compensation,” he wrote, explaining that realizing losses increases wealth by reducing taxes. However, he went on to note that normal investors are reluctant to realize losses. “Human nature being what it is, we are loath to take a loss until we are forced into it. Too often we believe that by ignoring a loss we will some day glance at the asset to find it has not only recovered its original value but has shown some appreciation.” (p. 116). Investors who exhibit the normal “human nature” behavior described by Snyder would have been branded irrational by Miller and Modigliani. Snyder’s normal investors deviate from rational behavior in two ways. First, they do not always prefer more wealth to less as rational investors do, since they forego the increment to their wealth brought by tax savings. Second, unlike rational investors, they are not indifferent whether a loss is labeled paper loss or realized loss. Snyder’s 1957 observations about the reluctance of normal investors to realize losses was reintroduced by Shefrin and Statman as the “disposition effect” in 1985, the early period of behavioral finance. Shefrin and Statman analyzed the disposition to sell winners too early and ride losers to long in a behavioral framework where investors are normal, affected by cognitive biases and emotions. A cognitive bias leads normal investors to consider their stocks one by one, in mental accounts distinct from the overall portfolio, and distinguish paper losses from realized losses. Normal investors are

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reluctant to realize losses because realization closes mental accounts at a loss, extinguishing all hope of recovery and inflicting the emotional pain of regret. There is something ironic in the1961 date of Miller and Modigliani’s argument that investors should be indifferent between dividends and capital. Investors were changing their minds about dividends and capital at the time, but they did not become indifferent between them. Instead, they were shifting from a preference for dividends to a preference for capital. John Clendenin exposed that shift in a 1960 article. “Back in 1951, with the uncertainties of depression and war still uppermost in their minds, stockholders expressed strong preferences for conservative stocks, cash dividends, and safety about all. In 1958, after seven years of prosperity and stock-market boom, a majority of the answers indicate a willingness to own speculative as well as conservative stocks, a less positive emphasis on cash dividends, and an interest in market profits which is almost as great as that in income and safety.” (p 48). Peter Bernstein observed the shift of preferences among his clients at the time. In a 2004 Financial Analyst Journal article he wrote “I recall a client on-the-make who came to me in the early 1960s. The first thing he said to me was ‘I can’t stand more income.’” (p. 7) Newcomers to investments were, in Bernstein’s words, “on the young side and financed their spending out of their incomes, or borrowings, and sensed no need to depend on dividends for that purpose. They socked their savings into 401(k) programs or played games like day trading, but depositing dividend checks has not been a matter of any interest.” (p. 8). The market efficiency hypothesis was new and threatening in 1965, when Fama introduced it in the pages of the Financial Analysts Journal. Fama wrote that “in an

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efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value.” (p. 56) In Fama’s market, unlike that of Benjamin Graham and Philip Fisher, there are no overpriced securities or underpriced ones. Earlier, in 1957, Robert Tucker wrote in the Financial Analysts Journal about Benjamin Graham’s value concept. “Security Analysts owe their very existence to the concept that value and price to not coincide. ‘Overpriced’ and ‘underpriced’ are adjectives repeatedly used in an analytical description of a security” (p.93). Benjamin Graham recommended that investors focus on value stocks while Philip Fisher (1958) recommended that they consider growth stocks as well. He wrote that investors should buy stocks “because they are outstanding and not just because they are cheap.” (p. 94) Some academics protested the increasing acceptance of the market efficiency hypothesis in the early 1960s. Robert Weintraub protested in a 1963 article. “In the past few years a number of academic papers have concluded that speculative price movements are random walks…I shall argue that random-walk hypothesis flies in the face of common sense and the facts and, moreover, suggests a degree of naïveté on the part of its advocates as to rules of the game which professional speculators are playing…It is a fact that there are professional traders who earn incomes from speculating on price movements… These men, in effect, earn their incomes by betting against the applicability of the random-walk hypothesis to price moves of less than 5 per cent.” (p. 59-61) Security analysts challenge the market efficiency hypothesis in their daily work. Block (1999) reported in the Financial Analysts Journal that only 2.7 percent of security analysts agreed strongly with the semi-strong form of the market efficiency hypothesis. Similarly, investors challenge the efficient market hypothesis in their daily investment

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behavior. Investors continue to allocate almost all their mutual fund money to active mutual funds that try to beat the market rather than to index funds that try to match it. Academics took longer to challenge the efficient market efficiency hypothesis but a series of anomalies uncovered in the late 1970s and early 1980s gave them pause. Market efficiency is intertwined with capital asset pricing models. Abnormal returns associated with size or book-to-market might be the result of market inefficiency or of a bad capital asset pricing model. As Fama (1991) wrote, “market efficiency per se is not testable” (p.1575). In 1992 Fama and French concluded that anomalies are reflections of a bad capital asset pricing model rather than an inefficient market and created the three-factor model where size and book-to-market are factors rather than anomalies. The number of factors in capital asset pricing models used by academics keeps growing, now including momentum and liquidity. Much of the distinction between rationality and irrationality in the investment context is a distinction between utilitarian and expressive characteristics. Expressive characteristics are those that enable normal people to identify their value, social class, and lifestyles and communicate them to others. A Timex watch and a Rolex watch have identical utilitarian characteristics, the show the same hour, but they have different expressive characteristics. A Timex conveys modesty and thrift while a Rolex conveys riches and ostentation. Statman (1999) described value stocks in the Financial Analyst Journal as the equivalents of Timex watches and growth stocks as the equivalents of Rolex watches. He called for capital asset pricing models that include both utilitarian and expressive characteristics. More recently, Fama and French (2004) called for similar models. Investors are interested in more than money payoffs, they wrote, they also want

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the pleasure of holding growth stocks or the virtue of holding socially responsible stocks, and their tastes might affect stock prices. So expressive characteristics, such as those associated with growth and social responsibility, have a place in asset pricing models. Fama and French’s 2004 article shows how great the change of mind has been since 1986, when Miller urged academics to stay away from ”family business, family quarrels, legacies received, divorce settlements, and a host of other consideration” he called distracting. We are moving toward asset pricing models that combine utilitarian and expressive characteristics and toward a better understanding of market efficiency. Markowitz wrote in his 1999 Financial Analysts Journal review that while the benefits of diversification were known before he introduced mean-variance portfolio theory, there was no “adequate theory of investment that covered the effects of diversification when risks are correlated, distinguished between efficient and inefficient portfolios, and analyzed risk-return trade-offs on the portfolios as a whole.” Indeed, there was no portfolio theory along the lines of mean-variance portfolio theory before Markowitz introduced it. But a portfolio theory did exist, a theory that underlies Shefrin and Statman’s (2000) behavioral portfolio theory. Investors in behavioral portfolio theory build their portfolios as layered pyramids where different assets, corresponding to different goals and different attitudes toward risk, fill the layers of the pyramid. The structure of portfolios as layered pyramids goes back many years. Weisenberger (1952) listed the layers of portfolios from bottom to top; income, balanced, growth and aggressive growth. Bonds are the right securities for the income layer, stocks with generous dividends, such as utility stocks, are right for the

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balanced layer, stocks that pay modest dividends are right for the growth layer and stocks that pay no dividends are right for the aggressive growth layer. Similarly, a 1929 article in The Literary Digest stated: “The first step in a safe and sane financial program is insurance…After insurance, the next requirement is to build up a cash reserve of at least $1,000 in the savings bank. After that, automatic thrift should be contracted for through installment savings plans, such as building-and-loan associations offer. When these fundamental steps have been taken, the investor is in position to acquire high-grade bonds and guaranteed first mortgages on real-estate. The next advance can be toward diversified preferred stocks, which offer a somewhat higher return….The last step should be outright purchase of the best grade of diversified common stock.” (p. 55). Some investors apply mean-variance optimizers to the construction of portfolios but that application is more ostensible that real. Users feed into the optimizer expected returns, standard deviations and correlations and the optimizer spits out asset allocations on the mean-variance efficient frontier. But the optimizer is no more than a prop. The important asset allocation choices are made through constraints such as ‘no more than 10 percent allocation to alternative investments.’ The true but unspoken framework for the discussion is behavioral portfolio theory that described the behavior of normal investors. In 1948, Milton Friedman and Leonard Savage described normal investors who buy insurance as if they are risk-averse while they also buy lottery tickets as if they are riskseeking. Today’s investors are equally normal. They form portfolios as layered pyramids ranging from a bottom downside protection layer that includes insurance policies to a top upside potential layer that includes lottery tickets.

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Conclusion Investors were normal before they were described as rational in the early 1960s and they remain normal today. Normal investors are affected by cognitive biases and emotions, while rational investors are not. Rational investors care only about the risk and expected return of their overall portfolios, while normal investors care about more than that. Wilford Eiteman sought to educate normal investors about dividend yield in a 1957 Financial Analysts Journal article. “The danger of current yield data lies in a tendency of uninformed investors to accept current yields as indicating the rate of return which they may expect...” (p. 13). Harry Comer sought to educate normal investors about stock splits in a 1958 Financial Analysts Journal article. “Recently a client asked if Bethlehem Steel did not look cheap ‘at 40.’ On being reminded that Bethlehem stock had split 12-for-1 since the war, and that a price of $40 now is equivalent to $480 per share for the stock which was priced around $75 at the end of the war, he said he had forgotten about the splits.” (p. 79). More recently, in the July/August 2004 issue of the Financial Analysts Journal, authors sought to educate normal investors that stock prices do not follow random walk, that sentiment associated with St. Patrick’s Day and the Jewish High Holy Days affects stock prices, that even professional traders are reluctant to realize losses, and that investors form portfolios by the rules of behavioral portfolio theory rather than those of mean-variance portfolio theory. Many years ago, in an early session of my economics studies, a professor asked if speculators stabilize prices or destabilize them. Speculators are greedy profiteers, said the

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first student. Speculators jump on price bandwagons and destabilize prices, said the second student. Then came my turn. I said that speculators always stabilize prices. Speculators are smart and they know when prices are too high or too low. They buy when prices are too low and sell when prices are too high and in the process they stabilize prices. “That is right!” said the professor, “What is your name?” I said my name, and I was proud, and I knew then and there that I would be an economist. But now I know that that my answer was wrong. Facts I did not know then but know now show that speculators stabilize prices at some times but destabilize them at others. I have changed my mind as facts changed. Much of finance has changed since the Financial Analysts Journal was founded in 1945, but the drive to uncover facts and make sense of them remains. Change of mind is an integral part of the process. As Maynard Keynes famously said “When the facts change, I change my mind. What do you do, sir?”

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