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 what’s in their best interest.  And they act on that knowledge.

3. Behavioral Economics also 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

4. Behavioral Finance Use 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

5. Procrastination and Under-saving Choi, Laibson, Madrian, Metrick (2002) Survey  Mailed to a random sample of employees  Matched to administrative data on actual savings behavior

6. 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 Solution Defaults 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

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. 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 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 company  You 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 allocation  Being passive is not an option

12. 401(k) participation increases under active decisions Active decision Standard enrollment

13. 13 2003 2004 2005 Third Solution Simplification Beshears, Choi, Laibson, Madrian (2006)

14. 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. 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. 16 Data from Harvard Staff Control Treatment Fees salient 3% of Harvard staff in Control Treatment put all $$$ in low-cost fund $494 $518 Fees from random allocation $431

17. 17 Data from Harvard Staff Control Treatment Fees salient 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 $494 $518 Fees from random allocation $431

18. 18 $100 bills on the sidewalk Choi, 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 Designers Use 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 20

21. 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

22. 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

23. 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.

24. The danger of narrow framing Consider a 55-year-old investor: 100,000 in equities in 401(k) +100,000 in bonds in 401(k)50% equities +100,000 DB pension33% equities +300,000 home16% equities +200,000 Social Security claim12% equities +300,000 NPV labor income 9% equities 24

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) 25

26. Total consumption (C+G) over GDP US NIPA 1952:1 to 2009:1 1998.1 2009:1