Behavioral Finance:

1

• Behavioral Finance
• Investment mistakes and solutions
• David Laibson
• Professor of Economics
• Harvard University
• National Bureau of Economic Research
• June, 2009

2
Mainstream economics

• Standard (or classical) assumptions
• People know whats in their best interest.
• And they act on that knowledge.

3
Behavioral Economicsalso known as Psychology
and Economics

• Better assumptions
• People sometimes get confused.
• Foreign stocks are risky.
• And even when we do understand whats best, we
  often dont follow through.
• Ill diversify my portfolio next month.
• Psychology Economics
• Nobel Prize (2002) to Daniel Kahneman

4
Behavioral Finance

• Use psychology and economics to understand
  finance

• Personal finance
• Procrastination
• Emotional choice
• Loss aversion
• Narrow Framing
• Return chasing
• Passivity
• Financial illiteracy
• Home bias
• Overconfidence
• Wishful thinking

• Corporate finance
• IPO timing
• Winners curse
• Cash-flow sensitivity
• Overconfidence
• Superstar CEOs

• Asset pricing
• Price Anomalies
• IPO underperformance
• Value Anomaly
• Sentiment
• Equity premium
• PEA drift
• Momentum
• Bubbles

5
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
7
First SolutionDefaultsAutomatic enrollment

• An example Welcome to the company
• If you dont 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

8
Madrian and Shea (2001)Choi, Laibson, Madrian,
Metrick (2004)
Automatic enrollment
Standard enrollment
9
Employees enrolled under automatic enrollment
cluster at default contribution rate.
Fraction of Participants at different
contribution rates
Default contribution rate under
automatic enrollment
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.

11
Second SolutionChoice-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 company
• You are required to submit this form within 30
  days of hire, regardless of your 401(k)
  participation choice
• If you dont want to participate, indicate that
  decision
• If you want to participate, indicate your
  contribution rate and asset allocation
• Being passive is not an option

12
401(k) participation increases under active
decisions
Active decision
Standard enrollment
13
Third Solution Simplification Beshears, Choi,
Laibson, Madrian (2006)
2005
2004
2003
14
Another problem High fees in 401(k) plans

• Take the Kimmel Center
• Philadelphias 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 DisclosureChoi,
Laibson, Madrian (2007)

• Experimental study with 400 subjects
• Subjects are Harvard staff members
• Subjects read prospectuses of four SP 500 index
  funds
• Subjects allocate 10,000 across the four index
  funds
• Subjects get to keep their gains net of fees

16
Data from Harvard Staff
Control Treatment
Fees salient
518
494
Fees from random allocation 431
3 of Harvard staff in Control Treatment put all
in low-cost fund
17
Data from Harvard Staff
Control Treatment
Fees salient
518
494
Fees from random allocation 431
3 of Harvard staff in Control Treatment put all
in low-cost fund
9 of Harvard staff in Fee Treatment put all
in low-cost fund
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

19
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

20
Two other psychological biases that are
particularly important in the aftermath of the
financial crisis

1. Return chasing
2. Narrow framing

21
Return chasing in 401(k)s

• 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
22
Households are otherwise being relatively passive

• 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

23
Passivity and return chasing work together to
produce reallocations

• 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 authors
calculations.
24
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

25
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)

26
Total consumption (CG) over GDPUS NIPA 19521
to 20091
20091
1998.1