Household Finance and Private Retirement Provision: A Marketing Finance perspective Piet Eichholtz Maastricht University

Marketing-Finance in Maastricht The Finance perspective  Start in 2007, anchored on Joost Pennings  Unique International MSc program: Marketing-Finance Interface  Very close link to financial industry  Alex chair and database  Fortis chair  Loyalis, SNS Reaal, …  Good fit with earlier research lines in Finance Department  Mutual funds  Pension research  Very good fit with existing research in private retirement provision  Individual investor behavior and attitudes  Product development

Alex platform provides unique perspective on private investment decisions  Option Trading and Individual Investor Performance  Rob Bauer, Mathijs Cosemans, Piet Eichholtz (2008)  Paper uses trading data set  Individual accounts between and  41,880 equity traders and 26,666 option traders  8 million trades, almost half in equities  Measure impact of trading on investor performance  Do investors understand risk/return?  Do investors have behavioral biases influencing performance?  Do they diversify adequately?  How and why do they use derivatives?  …

Related literature regarding private investor behavior and performance  Puzzling finding of prior research is excessive trading by private investors  Barber and Odean (2000): gains from trading insufficient to cover costs  Odean (1998): investors trade too much due to overconfidence  Investor irrationality in option markets  Poteshman and Serbin (2003): early exercise of options  Lakonishok et al. (2007): large fraction of option activity motivated by speculation  Strong evidence of performance persistence  Coval et al. (2005): small group of investors consistently beats markets

Average Investor Performance Raw monthly returns and alphas  Performance attribution using extension of Carhart (1997) four-factor model  Option-based factors added to capture nonlineair payoffs  IT factor added to capture tech-related style tilts

Investor sentiment and market timing Investors keep speculating on further market fall after recovery

Motivations for trading options (1) Type of position: put/call, own/write, covered/naked

Motivations for trading options (2) Selected results from online client survey  4,516 responses  2,323 option traders; 2,193 equity traders  Results suggest  overconfidence for option traders  speculation and entertainment more important for option traders

Performance Persistence (1)  Existing evidence  Coval et al. (2005): persistent winners outperform losers by 8% per year, unexplained by size, value, momentum  Brown and Goetzmann (1995), Carhart (1997): mixed evidence of performance persistence by mutual funds  Why would individuals be able to beat the market?  Price impact of trades is smaller  Fewer asset allocation constraints  Approach  Sort investors into decile portfolios based on return during formation period, calculate decile returns in evaluation period  T-test on performance difference between deciles 1 and 10  Spearman rank correlation formation and evaluation periods

Performance Persistence (2) Against hypothetical index fund and mutual fund

Performance Persistence (3) Decile performances and rank ordering

Performance Persistence (4) Investor characteristics

Conclusions  Individual investors incur large losses on option and equity investments  Poor performance explained by bad market timing due to overreaction to past market movements  Trading costs and lack of knowledge contribute to losses  Gambling and entertainment seems motivation for trading  Bad performers stay bad; good performers stay good  Trading hurts investor performance and trading options hurts most

Implications for private retirement provision  Left to their own devices, only a minority of citizens seem to be able to invest adequately for retirement  Some form of paternalism seems in place  The active mutual fund market does not provide a good answer  Bloated costs, too much trading, weak performance  David Swensen (2005): “Overwhelmingly, mutual funds extract enormous sums from investors in exchange for providing a shocking disservice.”  Mutual funds face a fundamental conflict of interest  The collective pension system has a better cost basis …  Bauer and Frehen (2008) … but does it provide enough flexibility and choice?

Two ways out I. Steering people towards passive strategies  Overwhelming academic evidence points to passive low-fee strategies  Exchange traded funds  Index funds  How do we get people into long term passive index funds?  The Swedish model (using a default fund) is a way out, but …  … does it steer people hard enough?  Many Swedes still chose top historical performer (high risk tech fund)  Only 4.1% of chosen funds were indexed  Very large home bias  … is the default choice the best choice for all?  What strategic mix of passive funds is optimal?

Two ways out II. Life cycle and complementary portfolios  Optimal portfolio changes with people’s life cycle and human capital  Willingness to run risk  Ability to make up for losses on the way  Optimal portfolio depends on non-financial portfolio  Position in housing market  Position in mortgage market  Design life cycle portfolios  Design complementary portfolios  Portfolio based on ALM at the client level  Adjust defaults accordingly and dynamically