behavioral finance david laibson robert i. goldman professor of economics harvard college professor...
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Behavioral Finance
David LaibsonRobert I. Goldman Professor of Economics
Harvard College Professor
Harvard University
National Bureau of Economic Research
November 17, 2008
Mainstream economics
Standard (or “classical”) assumptions:
People know what’s in their best interest. And they act on that knowledge.
Behavioral Economicsalso known as
Psychology and Economics
Better assumptions: People sometimes get confused.
“International equities make my portfolio more risky.” And even when we do understand what’s best, we
often don’t follow through.
“I’ll diversify my portfolio next month.”
Psychology + Economics
Nobel Prize (2002) to Daniel Kahneman
Behavioral FinanceUse psychology and economics to understand finance:
Asset pricing:
• Price Anomalies• Value Anomaly• IPO underperformance• Equity premium• PEA drift• Momentum • Bubbles
Corporate finance:
• IPO timing• Winner’s curse• Cash-flow sensitivity• Overconfidence • Superstar CEO’s
Household finance:
• Present Bias• Passivity• Procrastination• Financial illiteracy• Emotional choice• Return chasing• Loss aversion• Narrow Framing • Home bias• Overconfidence• Wishful thinking
Thought Experiment
Would you like to have
A) 15 minute Swedish massage now
or
B) 20 minute Swedish massage in an hour
Would you like to have
C) 15 minute Swedish massage in a week
or
D) 20 minute Swedish massage in a week and an hour
Choosing fruit vs. chocolateRead and van Leeuwen (1998)
TimeChoosing Today Eating Next Week
If you were deciding today,would you choosefruit or chocolatefor next week?
Patient choices for the future:
TimeChoosing Today Eating Next Week
Today, subjectstypically choosefruit for next week.
74%choosefruit
Impatient choices for today:
Time
Choosing and Eating
Simultaneously
If you were deciding today,would you choosefruit or chocolatefor today?
Time Inconsistent Preferences:
Time
Choosing and Eating
Simultaneously
70%choose chocolate
The desire for instant gratificationRead, Loewenstein & Kalyanaraman (1999)
Choose among 24 movie videos Some are “low brow”: Four Weddings and a Funeral Some are “high brow”: Schindler’s List
Picking for tonight: 66% of subjects choose low brow. Picking for next Monday: 37% choose low brow. Picking for second Monday: 29% choose low brow.
Tonight I want to have fun… next week I want things that are good for me.
Quantitative Model
Quasi-hyperbolic discounting (Laibson, 1997) Place full weight on present rewards and costs Place half weight on all future rewards and costs
ProcrastinationAkerlof 1991
Suppose that smoking has an immediate benefit of 6 and delayed health cost of 8.
Will you smoke today?
Smoke Today: 6 + ½ [-8] = 2 Smoke Tomorrow: 0 + ½ [6 - 8] = -1
Happy to make plans today to quit tomorrow. But likely to fail to follow through. Same pattern for smoking, diet, exercise, savings, etc….
Joining a GymDella Vigna and Malmendier (2004)
Average cost of gym membership: $75 per month Average number of visits: 4 Average cost per visit: $19 Cost of “pay per visit”: $10
14
Procrastination in retirement savingsChoi, Laibson, Madrian, Metrick (2002)
Survey– Mailed to a random sample of employees– Matched to administrative data on actual savings behavior
15
Typical breakdown among 100 employees
Out of every 100 surveyed employees
68 self-report saving too little 24 plan to
raise savings rate in next 2 months
3 actually follow through
The power of deadlines: Active decisions Choi, Laibson, Madrian, Metrick (2004)
Active decision mechanisms require employees to make an active choice about 401(k) participation.
Welcome to the companyYou are required to submit this form within 30 days of
hire, regardless of your 401(k) participation choice If you don’t want to participate, indicate that decision If you want to participate, indicate your contribution
rate and asset allocationBeing passive is not an option
401(k) participation increases under active decisions
401(k) participation by tenure
0%
20%
40%
60%
80%
100%
0 6 12 18 24 30 36 42 48 54
Tenure at company (months)
Active decision
Standard enrollment
Active decisions: conclusions
Active decision raises 401(k) participation.
Active decision raises average savings rate by 50 percent.
Active decision doesn’t induce choice clustering.
Under active decision, employees choose savings rates that they otherwise would have taken three years to achieve. (Average level as well as the entire multivariate covariance structure.)
What could you do? Ask service members to make an active choice.
0%
10%
20%
30%
40%
50%
0 3 6 9 12 15 18 21 24 27 30 33
Time since baseline (months)
Frac
tion
Eve
r P
artic
ipat
ing
in P
lan
2003
2004
2005
Simplified enrollment raises participationBeshears, Choi, Laibson, Madrian (2006)
Automatic enrollmentThe future of the TSP?
Welcome to the uniformed services If you don’t do anything
–You are automatically enrolled in the TSP –You automatically contribute 3% of your pay–Your contributions go into the G fund
Call this phone number to opt out of enrollment or change your investment allocations
Madrian and Shea (2001)Choi, Laibson, Madrian, Metrick (2004)
401(k) participation by tenure at firm
0%
20%
40%
60%
80%
100%
0 6 12 18 24 30 36 42 48
Tenure at company (months)
Automaticenrollment
Standard enrollment
3%
20% 17%
37%
14%9%
1%
67%
7%14%
6% 4%
1% 2% 3%–5% 6% 7%–10% 11%–16%
Contribution Rate
Before Auto Enrollment After Auto Enrollment
Employees enrolled under automatic enrollment cluster at default contribution rate.
Fraction of Participants at different contribution rates:
Default contributionrate under automaticenrollment
Participants stay at the automatic enrollment defaults for a long time.
Fraction of Participants Hired Under Automatic Enrollment who are still at both Default Contribution Rate and Asset Allocation
Company BCompany CCompany D
Fra
ctio
n of
Par
ticip
ants
Tenure at Company (Months)
Automatic enrollment
Participants hired under automatic enrollment tend to stay at the automatic enrollment defaults (about 75%)–Default saving rates–Default asset allocation
Automatic enrollment results suggest that employees are passive
Do workers like automatic enrollment?
In firms with standard 401(k) plans (no auto-enrollment), 2/3 of workers say that they should save more
When workers need to make active decisions, 70% join the 401(k) plan in the first three months of work
Opt-out rates under automatic enrollment are typically only 15% (opt-out rates rarely exceed 20%)
Under automatic enrollment (and even asset mapping) HR offices report “no complaints” in 401(k) plans
97% of employees in auto-enrollment firms approve of auto-enrollment.
Even among workers who opt out, approval is 79%.
26
Looking ahead
If the TSP does adopt automatic enrollment with a 3% saving rate and automatic asset allocation to the G fund, I recommend that you:– Nudge service members to choose a higher savings
rate (e.g., 10% of their income)– Nudge service members to choose a more aggressive
asset allocation (e.g., Lifecycle fund)
27
Emotional Decision-makingShiv and Fedorikhin (1999)
Cognitive burden/load is manipulated by having subjects keep a 2-digit or 7-digit number in mind as they walk from one room to another
On the way, subjects are given a choice between a piece of cake or a fruit-salad
Processing burden % choosing cake
Low (remember only 2 digits) 41%
High (remember 7 digits) 63%
28
Emotional system (dopaminergic targets)vs. Fronto-Parietal System
DopaminergicReward System(Affective/emotional)
Frontalcortex Parietal
cortex
29
Emotional system responds only to immediate rewards
y = 8mmx = -4mm z = -4mm0
7
T13
d = Earliest reward available todayd = Earliest reward available in 2 weeksd = Earliest reward available in 1 month
VStr MOFC MPFC PCC
Neu
ral
acti
vity
Seconds
McClure, Laibson, Loewenstein, and Cohen Science (2004)
0.4%
2s
30
x = 44mm
x = 0mm
0 15T13
VCtx
0.4%
2s
RPar
DLPFC VLPFC LOFC
Analytic brain responds equally to all rewardsPMA
d = Earliest reward available in 2 weeksd = Earliest reward available in 1 month
d = Earliest reward available today
31
0.0
-0.05
0.05
ChooseSmaller
ImmediateReward
ChooseLarger
DelayedReward
EmotionalSystem
Frontalsystem
Bra
in A
ctiv
ity
Brain Activity in the Frontal System and Emotional System Predict Behavior
(Data for choices with an immediate option.)
32
Conclusions of fMRI study
• Time discounting results from the combined influence of two neural systems:
Emotional limbic system is impatient Analytic fronto-parietal system is patient.
• Emotional brain, responds little to delayed rewards
• Emotional brain engenders taste for instant gratification
Financial education: Choi, Laibson, Madrian, Metrick (2004)
Seminars presented by professional financial advisors
Curriculum: Setting savings goals, asset allocation, managing credit and debt, insurance against financial risks
Seminars offered throughout 2000Linked data on individual employees’ seminar
attendance to administrative data on actual savings behavior before and after seminar
Effect of education is positive but small
Seminar attendees
Non-attendees
% planning to make change
% actually made
change
% actually made
change
Those not in 401(k) plan
Enroll in 401(k) Plan 100% 14% 7%Those already in 401(k) plan
Increase contribution rate 28% 8% 5% Change fund selection 47% 15% 10% Change asset allocation 36% 10% 6%
Summary
Present bias: current rewards get full weight while future rewards get half weight.
Self-defeating behaviors and retirement savings
Practical solutions that overcome passivity or exploit it.
1. Ask people to make an active choice
2. Simplify enrollment
3. Use automaticity
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