The Impact of Behavioral Economics on Investor Decision-Making

Ulrike Malmendier Edward J. and Mollie Arnold Professor of Finance, Haas School of Business, and Professor of Economics, Department of Economics University of California, Berkeley Ph.D. in Business Economics from Harvard University (2002) Ph.D. in Law from the University of Bonn (2000) 2013 Fischer Black Prize, awarded biennially by the American Finance Association to the leading finance scholar under 40 Research: behavioral finance, corporate finance, behavioral economics, including M&A, corporate governance and the effects of financial crises on individual and managerial behavior.

Classical Economics Assumptions  Investors are consistent in their preferences.  Investors are consistent in their attitudes toward risk.  Investors are consistent in their discount rates.  Every financial choice is reducible to impact on wealth.  All wealth effects are fungible.

Behavioral Economics Assumptions  Investors are inconsistent.  Investors are subject to framing effects.  Investors do not treat the effects of their choices as fungible.  This is referred to as “mental accounting.” Today: three examples.

Example 1: (In-)Consistency o Many financial investment choices are available repeatedly. o Our retirement funds are invested in easier high-risk or low-risk assets, every day until we retire, or perhaps until we die. o How do people make such repeated choices? o How should they?

Samuelson Gamble o Paul Samuelson (Nobel Prize 1970) to his colleague: I propose the following gamble: Flip a coin: If its heads you win $200; if its tails you pay $100. Would you take it?

Samuelson Gamble o Other professor’s response: No. But if you let me do it 100 times, I will take it.

The Classic Economist Samuelson got incredible upset … inconsistent! “If you don’t like to exchange your current wealth against current wealth + 200; -100 with 50/50, then you should not exchange it against +20,000/-10,000.”

The Behavioral Economist The one-shot gamble entails a 50/50 chance of going home and explaining a non-trivial loss of $100. (In 1963!) The series of 100 bets entails an expected gain of $5000, and a chance of losing money of less than one half percent. BUT: It is inconsistent  Myopic Loss Aversion

Prospect Theory

Inconsistent Attitudes Toward Risk o Investor who turns down the bet offered above would also have to turn down gambles with much higher stakes. o Traditional utility theory assumes constant “coefficient of risk aversion” o Yet investors apply different coefficient.

Mental Accounting Investors tend to segregate the different types of investment into separate accounts, and ignore possible interaction.  This is why it is so hard to use the diversification argument (“hold the market portfolio”) with your clients!

A couple of stark examples Investors seem too risk averse over gambles that have trivial impact on wealth:  Phone company wire insurance  Best Buy warranties  Low deductible, low limit insurance  Collision Damage Waivers Serve as “money pump” for sellers of insurance

Prospect Theory

o Gains and losses require a reference point. o Reference point is specific to the choice. o Investors have discretion in how to frame the reference point.

Implication: Hedonic Framing Who is happier? o Someone who wins two lotteries that pay $50 and $25 separately, or o Someone who won one lottery that pays $75? Same for losses. But losses matter more than gains.

Common mistake of “Counting Your Money” o Every time you check the value of your portfolio you partially reset your reference point. o Investors shown annual volatility will take more risk than those shown monthly volatility.

Reference Point Management o If losses are more painful than gains, But gains have diminishing utility, and Losses have diminishing disutility o It pays to: Aggregate losses Enjoy gains separately Embed a loss in a gain Applies one to one to financial advising!

Reference Points & Financial Products 1.Focus on “portfolio of investments,” rather than individual investments. 2.Single out “winners.”

Example 2: Discount Rates o Classical Economics assumes that all investors have a positive discount rate. o That discount rate is applied consistently across domains. o If true investors would accelerate good things, defer negative things. o Frequently Violated

Negative Discount Rates Examples o Tax refunds o Salary plans o Failure to consider life cycle costs Copiers Credit cards Gym membership

Hyperbolic Discounting Would you like to have A)$10 now or B) $11 tomorrow Would you like to have C) $10 in a week or D) $11 in a week and a day

Fruit versus Chocolate If you were deciding today, would you choose fruit or chocolate for desert next week? 74% choose fruit

Fruit versus Chocolate If you were deciding today, would you choose fruit or chocolate for desert today? 70% choose chocolate

Implication: PROCRASTINATION Suppose you can exercise (effort cost 6) to gain delayed benefits (health value 8). When will you exercise? Exercise Today: -6 + ½ [8] = -2 Exercise Tomorrow: 0 + ½ [-6 + 8] = 1 Happy to make plans today to exercise tomorrow. But likely to fail to follow through.

“Paying Not to Go to them Gym” (DellaVigna and Malmendier 2004) Average cost of gym membership: $80/month or $10/visit Average number of visits of those who enroll: 4 per … month (not week!) Average cost per visit: $20

Self-Defeating Behavior Patient activities many of us plan to do tomorrow: Quit smoking. Floss. Clean the attic. Comply with prescriptions. Cut back credit card spending. Join retirement savings plan.

You understand, but …

Procrastination and Retirement (Choi, Laibson, Madrian, Metrick 2002) Survey: Mailed to 590 employees. Matched to data on actual savings behavior. Findings 68% report saving too little. 24% plan to raise 401(k) contribution in next 2 months. Only 3% actually do so in the next 4 months.

Implications for Investors Most investors do not invest in a manner consistent with their retirement goals. Most investors do not invest enough. Most investors do not calibrate their portfolios to their risk preference. (“Path Dependence”)

$100 bills on the sidewalk o Employer match of 401(k) saving is instantaneous, riskless return on investment. o Particularly appealing if > 59½ years old: Retirement close  should be thinking about it. Can withdraw from 401(k) without penalty. Have the most experience, so should be savvy. Half of employees over 59½ yrs are not (fully) exploiting their employer match. Average loss = 1.6% of salary per year. Educational intervention has no effect.

Inertia o Classical economic theory says that framing of decision should not impact decision. o Yet decision makers frequently choose default through inaction. o Opting in vs. Opting Out o Default contribution rates o Default investment allocations  If client has made a decision for an investment (wants to invest!), make implementation the default.

Automatic Enrollment

Automatic Enrollment: Implications o Automatic enrollment dramatically increases 401(k) participation. o Participants hired under automatic enrollment tend to stay at the automatic enrollment defaults. o Similar default effects are observed for cash distributions at termination company stock asset allocations saving rates at match thresholds

Employees enrolled under automatic enrollment cluster at the default contribution rate.

Employees enrolled under automatic enrollment infrequently reallocate.

Employees enrolled under automatic enrollment invest in employer stock if default.

Implications o Investors procrastinate. o Investors are naïve about their future procrastination. o Power of Opting in versus Opting out o Power of Defaults

Example 3: Naïve Diversification o Classical Economics predicts that investors will invest in “the market portfolio + safe assets”  broadest possible diversification. Mean-variance efficient o Behavioral Economics (and Reality!) says they will avoid risk because of loss-aversion (unless bundled/portfolio), they will procrastination re- allocating and optimizing (unless default) o Classical Economics also says: asset mix should not be affected by the way the choices are presented.

Behavioral Economics says …

Naïve Diversification o Investors tend to follow the 1/N rule. o If offered one equity and one debt fund, they will invest o If offered three equity funds and one debt fund, they will allocate 75% to equity an 35% to debt.  Combine with path-dependence, and you understand the hurdle for alternative investments!

Takeaways o Investors sometimes have incorrect theories about what is in their best interest. “I’ll diversify across index funds.” o And even when investors do understand what’s best, they often don’t follow through. “I’ll enroll in my 401(k) next month.”

Takeaways There are ways to overcome mistakes / passivity: 1.Present results in a “portfolio.” 2.Make investment the default, or use deadlines to short-circuit procrastination. 3.Get in there early (investment of first earnings, first savings etc.) – not when investor has become “high net worth.” Broader investment choices need to be integrated into the “menu” offered initially.

THANK YOU!