behavioral finance: investment mistakes and solutions david laibson professor of economics
DESCRIPTION
Behavioral Finance: Investment mistakes and solutions David Laibson Professor of Economics Harvard University National Bureau of Economic Research June, 2009. Mainstream economics. Standard (or “classical”) assumptions: People know what’s in their best interest. - PowerPoint PPT PresentationTRANSCRIPT
Behavioral Finance:Investment mistakes and solutions
David LaibsonProfessor of Economics
Harvard University
National Bureau of Economic Research
June, 2009
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.
“Foreign stocks are 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• IPO underperformance• Value Anomaly • Sentiment• Equity premium• PEA drift• Momentum • Bubbles
Corporate finance:
• IPO timing• Winner’s curse• Cash-flow sensitivity• Overconfidence • Superstar CEO’s
Personal finance:
• Procrastination• Emotional choice• Loss aversion• Narrow Framing • Return chasing • Passivity• Financial illiteracy• Home bias• Overconfidence• Wishful thinking
Procrastination and Under-savingChoi, Laibson, Madrian, Metrick (2002)
Survey Mailed to a random sample of employees Matched to administrative data on actual savings
behavior
6
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
First SolutionDefaults
Automatic enrollment
An example: Welcome to the company If you don’t do anything
–You are automatically enrolled in the 401(k) –You save 2% of your pay–Your contributions go into a default 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
10
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
Opt-out rates under automatic enrollment are typically only 10% (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 of automatic enrollment, approval is 79%.
Even the US government is discussing adoption of automatic enrollment.
Second Solution:Choice-based regimes: 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
0%
20%
40%
60%
80%
100%
0 6 12 18 24 30 36 42 48 54
Tenure at company (months)
401(k) participation by tenure
Active decision
Standard enrollment
13
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
Third SolutionSimplification
Beshears, Choi, Laibson, Madrian (2006)
14
Another problem:High fees in 401(k) plans
Take the Kimmel Center:Philadelphia’s answer to the Kennedy Center
In their 401(k) plan, fees are very high.
Consider equity funds:• Lowest expense ratio: 1.27%• Highest expense ratio: 2.43%
15
Fourth solution? Education and Disclosure
Choi, Laibson, Madrian (2007)
Experimental study with 400 subjects Subjects are Harvard staff members Subjects read prospectuses of four S&P 500 index funds Subjects allocate $10,000 across the four index funds Subjects get to keep their gains net of fees
16
$255
$320
$385
$451
$516
$581
Data from Harvard Staff
Control TreatmentFees salient
3% of Harvard staffin Control Treatment
put all $$$in low-cost fund
$494$518
Fees from random allocation$431
17
$255
$320
$385
$451
$516
$581
Data from Harvard Staff
Control TreatmentFees salient
3% of Harvard staffin Control Treatment
put all $$$in low-cost fund
9% of Harvard staffin Fee Treatment
put all $$$in low-cost fund
$494$518
Fees from random allocation$431
18
$100 bills on the sidewalkChoi, Laibson, Madrian (2004)
Employer match is an instantaneous, riskless return on investment
Particularly appealing if you are over 59½ years old– Have the most experience, so should be savvy– Retirement is close, so should be thinking about saving– Can withdraw money from 401(k) without penalty
We study seven companies and find that on average, half of employees over 59½ years old are not fully exploiting their employer match– Average loss is 1.6% of salary per year
Educational intervention has no effect at all
Regulators and Plan DesignersUse Defaults to…
Make constructive outcomes automatic or easy– Enrollment– High savings rates and escalation of savings– Diversification– Rebalancing– Individualization (e.g. age-based)– Fee reduction– Annuitization
Make destructive outcomes hard Adopt educational interventions but pair them
with simultaneous opportunities for action
Two other psychological biases that are particularly important in the aftermath of
the financial crisis
1. Return chasing
2. Narrow framing
20
Return chasing in 401(k)’s
21
At year-end 2007, 68% of employee contributions were being directed into equities.
At year-end 2008, 57% of employee contributions were being directed into equities.
Source: Hewitt Associates
Households are otherwise being relatively passive:
22
Among participants, 401(k) contribution rate fell slightly: 7.7% in 2007 and 7.4% in 2008
Savings plan participation in 401(k)’s barely changed: 73.9% in 2007 and 74.2% in 2008
Passivity and return chasing work together to produce reallocations:
23
Equity allocation fell from 67.7% in 2007 to 59.0% in 2008.
Allocation decline is accounted for by a basically passive response to the decline in equity values
Source: Hewitt Associates and author’s calculations.
The danger of narrow framingConsider a 55-year-old investor:
100,000 in equities in 401(k)
+100,000 in bonds in 401(k) 50% equities
+100,000 DB pension 33% equities
+300,000 home 16% equities
+200,000 Social Security claim 12% equities
+300,000 NPV labor income 9% equities
24
Conclusion
Use automatic features for enrollment, savings and asset allocation
Discourage active and passive return chasing– Automate asset allocation for individual investors– Target Date Funds provide automatic rebalancing at
annual frequencies and automatic equity reallocation at lifecycle frequencies
Encourage broad framing in retirement planning– Integrate across assets (and make sure workers have
a reasonable exposure to equities in their total portfolio)
25
Total consumption (C+G) over GDPUS NIPA 1952:1 to 2009:1
1998.1
2009:1