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