In January, Goldman Sachs Group offered shares in privately held Facebook to a select few of its clients. A couple of weeks later, the firm, concerned about violating U.S. securities laws, decided to restrict the offering to non-U.S. investors. Its American clients, however, did not leave empty-handed. Their status is higher, and their pride greater, now that they have been certified as members of Goldman’s inner circle.
As a professor of finance specializing in behavioral finance, I have spent much of my career studying cognitive errors made by investors and their misleading emotions. But investors — be they Goldman clients, currency traders or pension fund managers — are not intentionally misguided. Rather, they lose their way as they try to make sense of the investment benefits they seek.
Financial actions can have three types of benefits: utilitarian, expressive and emotional. Utilitarian benefits answer the question, What does it do for me and my pocketbook? The utilitarian rewards of buying a watch include the ability to tell time. The payoff of owning Facebook shares is a potentially high return (although, with a pre-IPO company valuation of $50 billion, that is debatable).
Expressive benefits convey to us and others our values, tastes and status. They answer the question, What does it say about me? A lucky Goldman client says, “My status is high enough to be selected to invest in Facebook shares.”
Emotional rewards answer the question, How does it make me feel? Insurance policies make us feel safe, lottery tickets give us hope, and a chance to be among the first to own Facebook shares makes us proud.
I see nothing wrong with Goldman’s wealthy clients investing $2 million or more in Facebook shares. Their money belongs to them and, in any event, they would not lack for bread or butter even if their $2 million were to vanish. But I see much wrong when pension fund managers, especially those who oversee public funds, sacrifice utilitarian investment returns for their own expressive and emotional benefits by trading currencies or picking alternative investments. As a taxpayer, I will have to pay for their indulgence, helping to foot the bill for the retirement and health benefits of public employees.
A manager of a public pension fund recently protested when I presented my list of investment benefits. “All I want is a positive alpha,” he said. Maybe so, but managers of pension funds generate, on average, negative alphas. Gary Brinson, L. Randolph Hood and Gilbert Beebower’s 1986 article “Determinants of Portfolio Performance” is celebrated for demonstrating that strategic asset allocation is more important than tactical asset allocation and security selection. But what it really demonstrates is that pension fund managers generate negative alphas.
Cognitive errors and misleading emotions, including overconfidence, blind many investors to their perverse skill at generating negative alphas. Such failings are not unique to individual investors; they are often joined by institutional investors, whom Wall Street bankers flatter as being sophisticated players, just before they are fleeced.
Goldman chief executive Lloyd Blankfein defended his firm’s actions before the mortgage crisis, saying the collateralized debt obligations and other securities Goldman sold had “delivered the specific exposure that the client wanted to have.” But Philip Angelides of the Financial Crisis Inquiry Commission didn’t buy Blankfein’s defense. He chided the Goldman CEO for taking advantage of pension fund managers, who hold the life savings of police officers and teachers.
Too many pension fund managers believe that they have a good chance to win the investment game, when, in truth, they are overconfident and unrealistically optimistic. Public funds will never have what it takes to win against the likes of Goldman. They should acknowledge that they will lose every game and protect themselves by playing as few as possible.
The recent crisis induced Goldman to expand its fiduciary duties. The firm will now hold the hands of individual investors and less-sophisticated institutional investors, including public pension funds, more tightly than in the past. Perhaps Goldman and fellow financial sellers will one day also educate buyers about the utilitarian, expressive and emotional benefits of investments and guide them to wise trade-offs. In the meantime, I’d like to see public pension funds ask job candidates if they enjoy the investment game and think that they are good at it, able to pick winning managers and investments. Candidates who answer yes should be disqualified.
Meir Statman is the Glenn Klimek Professor of Finance at Santa Clara University’s Leavey School of Business and author of What Investors Really Want (McGraw-Hill).
