Dear Irrational (from a finance professor)
Dear Irrational,
I am a finance professor at one of the top business schools in the U.S., and I am starting to doubt the assumptions of irrationality based on what I see in my students.
Here is the story: Every year when I teach the basic finance class to either the MBAs or the executive MBAs we get to the point where we talk at length about the benefit of diversification, including how to think about risk and return.
Every year, I have made it the point of the class to emphasize how important it is to diversify, including the importance of diversification in their employee stock.
Every year I spend more time on this very clear and simple issue, and every year I come to the realization that they do not care or don’t remember this very simple lesson. My best example of this is a recent graduate, who took my class, and took a position with Bear Sterns. He was partly compensated with shares and options and he recently called to tell me how much he regretted not applying my warning. How can it be that such a smart student failed to take such a simple but important lesson?
So I am turning to you (ironic, I know). What can I do so that this lesson will get etched in their minds?
Yours truly,
A frustrated finance professor
Dear frustrated finance professor,
Here is what I would do:
First, it turns out that people do not learn or remember abstract lessons as well—so you need to make it concrete (this is why Harvard business cases are so often used—not because they are so great, but because students remember the story in them). I would use the example of the student from your class, I would ask for his permission and I would use his picture and life story to present an analysis on how much he lost. If he will come to the class to tell about his mistake this will be particularly powerful (maybe you can also take a video of him talking about his experience). I suspect that such a personal example will be very helpful in getting the students to remember the lesson.
Another idea is to make them a keychain, or a pen with the word “always diversify” on it, with the idea that if they use it they will have a constant reminder about their own pledge to diversity. Another approach to the same idea would be to use the school rings, if some people at your university get school rings, maybe you can get the words “always diversify” etched on the ring and this way they will remember this lesson.
A third approach would be to pair them up with another student and for each pair to agree that once a year they will review the financial allocation of the other person and give them neutral feedback about their allocations. This way they will get a checkup once a year on the wisdom of their decisions and will have to explain this to another person who is not invested in their finances.
Finally, get them a certificate at the end of your class saying that they now understand something about finance, and that they pledge to always diversify and get them to sigh this certificate and hang it on the wall in their office. Presumably the signature and pledge will remind them what they need to do.
If you end up trying one of these please let me know what you think.
Irrationally yours
Dan
Professor Dan, I do not think diversification is the answer in today’s market. I have been promoting gold in small amounts as a key to financial security. I guess I was right.
Your trusted CFP.
Diversification may not be the complete answer to today’s markets, but it helps you avoid situations the employees of Lehman and Bear Stearns found themselves in. If they had diversified their own holdings away from their company, they would have come out less bruised than they are now.
It should be obvious that, unless you control the direction of the company, you should not be heavily invested in that company. After all, if the company hits a rough patch, you lose not only on your investment, but also potentially your job and income. That’s a double whammy you should avoid at all costs.
Dan, you might try thinking in terms of bounded rationality. Most theories of rationality ignore the costs of cognition and the fact that with each additional stock added to a portfolio, the costs in terms of mental processing increases. There is likely a point (a relatively low point) when the number of different stocks becomes more costly than the perceived benefit, so that they are acting rationally within the bounds set by cognitive costs.
I worked for a large UK company that offered an attractive looking share save scheme and bonuses with a choice of cash or shares. I had an economics lecturer who also preached diversification. He told us a story of his own experience with share schemes in a company that went under. Basically resulted in him becoming a lecturer. He used to say “Diversify or you could end up teaching you, like me!”. I think that helped me remember it anyway!
I chose not to take part in the scheme and took the cash instead of the shares.
Collegues advised me to take all share options that I could, since they had been with the company for many years and it had always worked out for them.
Oh, and the company I used to work for. Northern Rock plc.
If you are not familiar search for them in conjunction with the term ’2007 credit crisis’.
Also a comment on the gold investing. It is an investment like any other and thus incurs its own opportunities and threats. Sometimes it will work in your favour, sometimes it will not. Too much to go into here but do your research before sticking all your money into gold. Search the net for ‘investing in gold is bad” and read a few articles. Oh and also, one of my favourite quotes:
“It gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.” – Warren Buffet
For stability, stick with sensible informed diversity.
People are basically lazy. Why did the student in question not diversify? Probably because the acquisition of the stock(s) was passive. So, is this a case of get something for nothing, or a case of getting nothing for your something?
I’m all for diversification, but just to play devil’s advocate…doesn’t diversification defeat the purpose of giving an employee stock options from an employer’s perspective? Yes, they are a financial bonus, but the underlying purpose is to tie the employee’s compensation directly to the stock price and give the employee a reason to enhance shareholder value. An employer could create a graduated vesting schedule to achieve the intended purpose, but aren’t there tax consequences to doing so? I’m not sure if there are safe harbor provisions regarding stock options.