Behavioral Finance David Laibson Harvard University

Behavioral Finance David Laibson Harvard University Annual Meeting CFP Board August 2006

Mainstream economics
Standard (or “classical”) assumptions:
Individuals know what’s in their best interest.
And they act on that knowledge.

Behavioral Economics also known as Psychology and Economics
Better assumptions:
Actors sometimes have bad theories about what is in their best interest.
“ My employer’s stock is less risky than a mutual fund.”
And even when actors do understand what’s best, they often don’t follow through.
“ I’ll write my will next month.”
Psychology + Economics
Nobel Prize (2002) to Daniel Kahneman

Behavioral Finance
Use psychology and economics to understand finance:
Asset pricing:
Price anomalies
Equity premium
PEA drift
Momentum
Value strategy
Bubbles
IPO underperformance
Arbitrage violations
Corporate finance:
Cash-flow sensitivity
Overconfidence
Winner’s curse
Superstar CEO’s
Personal finance:
Financial illiteracy
Wishful thinking
Return chasing
Loss aversion
Framing
Procrastination
Passivity
Myopia

Asset pricing example.
March 2000
3Com owns Palm and other net assets, but...
Palm has higher market cap than 3Com
$3Com = $(Palm + Other Net Assets) < $Palm
Are financial markets efficient?!

Corporate finance example.
When oil prices are high, oil companies increase their investment in their non-oil subsidiaries – for instance, an entertainment subsidiary.
Cash-flow from the petroleum business should not drive investment in unrelated businesses.

Personal finance: today’s talk
Financial confusion: a mutual fund study
Procrastination
Psychological Foundations
Behavioral Model
Consequences for retirement saving
Neuroeconomics

1. Financial confusion: mutual fund fees Choi, Laibson, Madrian (2006)
Mutual fund fees vary by a factor of 10 within asset classes.
Little evidence that more expensive funds pick stocks well enough to justify higher fees (e.g. Carhart, 1997; Gruber, 1996; Hortacsu and Syverson 2005)
Hundreds of competing firms
Why doesn’t competition drive prices down to the same low level?
Mutual fund industry: variation in non-portfolio services explains why customers are willing to pay higher fees at some firms (ICI, 2005)

An experiment that tests these theories
Subjects allocate $10,000 among four funds
Randomly choose two subjects to receive any positive portfolio return during the subsequent year
Eliminate variation in pre-fee returns
Choose among S&P 500 index funds
Unbundle services from returns
Experimenters pay out portfolio returns, so no access to investment company services

One year of index fund fees on a $10,000 investment

Fees paid in control condition Minimum Possible Fee Maximum Possible Fee t-test: p=0.5086 N = 83 N = 30 $443: average fee with random fund allocation 0% of College Controls put all funds in minimum-fee fund 6% of MBA Controls put all funds in minimum-fee fund

What if you pass out a sheet summarizing fees? t-tests: MBA: p=0.0000 College: p=0.1451 N = 83 N = 30 N = 29 N = 85 ** 10% of College treatment put all funds in minimum-fee fund 19% of MBA treatment put all funds in minimum-fee fund

What about a sheet with returns since inception? N = 83 N = 30 N = 28 N = 84 t-tests MBA: p=0.0813 College: p=0.0008 **

Investor confidence and fees N = 64 N = 46 N = 36 N = 136 t-tests: MBA 1 vs. 2, p=0.2013; MBA 1 vs. 3, p=0.0479; College 1 vs. 2, p=0.2864; College 1 vs. 3, p=0.3335 N = 50 N = 5 *

Conclusions of mutual fund fees study
Many investors don’t understand the importance of fees
Control college students don’t rank fees as important
Investors who do understand the importance of fees still do not respond to fees
MBA controls rank fees as most important, but only 6% put all funds in minimum fee fund
MBA controls do not pay less in fees than college student controls
Making fees transparent (implicit education)
Causes investors to shift some money to low-cost funds
Does not induce optimal use of fee information (even in fee treatment, only 19% of MBA’s put all funds in minimum-fee fund)
Irrelevant returns information distracts investors

2. Procrastination i. Psychological Foundations
Would you like to have
15 minute massage now
or
B) 20 minute massage in an hour
Would you like to have
C) 15 minute massage in a week
or
D) 20 minute massage in a week and an hour

Choosing fruit vs. chocolate Read and van Leeuwen (1998) Time Choosing Today Eating Next Week If you were deciding today , would you choose fruit or chocolate for next week ?

Patient choices for the future: Time Choosing Today Eating Next Week Today , subjects typically choose fruit for next week . 74% choose fruit

Impatient choices for today: Time Choosing and Eating Simultaneously If you were deciding today , would you choose fruit or chocolate for today ?

Time Inconsistent Preferences : Time Choosing and Eating Simultaneously 70% choose chocolate

The desire for instant gratification Read, Loewenstein & Kalyanaraman (1999)
Choose among 24 movie videos
Some are “low brow”: Four Weddings and a Funeral
Some are “high brow”: Schindler’s List
Picking for tonight: 66% of subjects choose low brow.
Picking for next Thursday: 37% choose low brow.
Picking for second Thursday: 29% choose low brow.
Tonight I want sugar-coated entertainment… next week I want things that are good for me.

ii. Behavioral Model
Quasi-hyperbolic discounting (Laibson, 1997)
Discounted utility function
U t = u t + ½  u t+1  u t+2  u t+3 
Discounted utility from the perspective of time t+1.
U t+1 = u t+1 + ½  u t+2  u t+3 
Discount function reflects dynamic inconsistency: preferences held at date t do not agree with preferences held at date t+1.

Procrastination Akerlof 1991
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.

iii. Self-defeating behaviors
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.

Joining a Gym Della Vigna and Malmendier (2004)
Average cost of gym membership: $75 per month
Average number of visits: 4
Average cost per vist: $19
Cost of “pay per visit”: $10

Saving for retirement Laibson, Repetto, and Tobacman (2004)
Need impulsivity to explain lifecycle consumption facts:
Substantial illiquid retirement wealth: W/Y = 3.9.
But, extensive credit card borrowing:
68% didn’t pay their credit card in full last month
Average credit card interest rate is 14%
Credit card debt averages 13% of annual income
Why do we see both saving and borrowing?!
Patient long-run view leads us to set up automatic savings institutions (home mortgage, pensions)
Impatient short-run view leads us to postpone sacrifices, so we spend on credit cards today

Procrastination in retirement savings Choi, Laibson, Madrian, Metrick (2002)
Survey
Mailed to 590 employees (random sample)
195 usable responses
Matched to administrative data on actual savings behavior
Consider a population of 100 employees
68 report saving too little
24 of 68 plan to raise 401(k) contribution in next 2 months
Only 3 of 24 actually do so in the next 4 months

The power of deadlines: 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

401(k) participation increases under active decisions

Active decisions: conclusions
Active decision raises 401(k) participation.
Active decision raises average savings rate by 50 percent.
Active decision doesn’t induce choice clustering.
Under active decision, employees choose savings rates that they otherwise would have taken three years to achieve. (Average level as well as the entire multivariate covariance structure.)

Automatic enrollment
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 money market fund
Call this phone number to opt out of enrollment or change your investment allocations

Madrian and Shea (2001) Choi, Laibson, Madrian, Metrick (2004)

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

Participants stay at the automatic enrollment defaults for a long time.

Automatic enrollment A DB plan in disguise?
Automatic enrollment dramatically increases 401(k) participation
Participants hired under automatic enrollment tend to stay at the automatic enrollment defaults
Default saving rates
Default asset allocation
Automatic enrollment evidence suggests that employees are excessively passive

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

Unsuccessful “solutions” to savings problems
Paying employees to save:
matches don’t work
Educating employees:
financial education (alone) doesn’t work

$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 savy
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

Financial education: Choi, Laibson, Madrian, Metrick (2004)
Seminars presented by professional financial advisors
Curriculum: Setting savings goals, asset allocation, managing credit and debt, insurance against financial risks
Seminars offered throughout 2000
Linked data on individual employees’ seminar attendance to administrative data on actual savings behavior before and after seminar

Treatment effect is positive but small 6% 10% 36% Change asset allocation 10% 15% 47% Change fund selection 5% 8% 28% Increase contribution rate Those already in 401(k) plan 7% 14% 100% Enroll in 401(k) Plan Those not in 401(k) plan % actually made change % actually made change % planning to make change Non-attendees Seminar attendees

Financial education effects are small
Seminar attendees have good intentions to change their 401(k) savings behavior, but most do not follow through
Financial education alone will not dramatically improve the quality of 401(k) savings outcomes
We have also studied the effect of the Enron/Worldcom/Global Crossing scandals on employer stock holdings
No net sales of employer stock in reaction to these news stories

iv. Neuroeconomics Shiv and Fedorikhin (1999)
Cognitive burden/load is manipulated by having subjects keep a 2-digit or 7-digit number in mind as they walk from one room to another
On the way, subjects are given a choice between a piece of cake or a fruit-salad
59% High (remember 7 digits) 37% Low (remember only 2 digits) % choosing cake Processing burden

Limbic system vs. Fronto-Parietal System Limbic system Frontal cortex Parietal cortex

Hypothesis: Limbic system discounts reward at a higher rate than does the prefrontal cortex. Discounted value of delayed reward time prefrontal and parietal cortex limbic system 0.0 1.0

McClure, Laibson, Loewenstein, and Cohen Science (2004)
Do agents think differently about immediate rewards and delayed rewards?
Does immediacy have a special emotional drive/reward component?
Does emotional (limbic) brain discount delayed rewards more rapidly than the analytic (fronto-parietal cortex) brain?

Two kinds of choices (d vs. d’) :
delay d>0 d’
Reward R R’
Hypothesis: fronto-parietal cortex .
delay d=0 d’
Reward R R’
Hypothesis: fronto-parietal cortex and limbic .
Time Time

Methods Subjects given a series of choices between ($R at d) and ($R' at d') where R<R' and d<d'. 2 s 12 s Free Response

x = -4mm 0 7 T 13 ventral striatum posterior cingulate cortex medial PFC medial OFC hippocampus medial OFC ventral striatum Emotional brain (limbic system) only shows elevated activation when a subject considers an immediate reward. y = 8mm z = -4mm

Limbic brain responds only to immediate rewards BOLD Signal Seconds y = 8mm x = -4mm z = -4mm 0 7 T 13 d = Today d = 2 weeks d = 1 month 0.2% 2s VStr MOFC MPFC PCC

 Areas respond equally to all rewards x = 44mm x = 0mm d = Today d = 2 weeks d = 1 month 0 15 T 13 VCtx 0.4% 2s PMA RPar DLPFC VLPFC LOFC

0.0 -0.05 0.05 Choose Immediate Reward Choose Delayed Reward Limbic System Frontal system Brain Activity Brain Activity in the Frontal System and Limbic System Predict Behavior (Data for choices with an immediate option.)

Conclusions of fMRI study
Time discounting results from the combined influence of two neural systems:
Limbic structures are impatient
Fronto-parietal systems are patient.
These two systems are separately implicated in ‘emotional’ and ‘analytic’ brain processes.
The limbic (emotional) brain, does not value delayed rewards
The limbic brain creates a drive for instant gratification

Summary
Investors sometimes have incorrect theories about what is in their best interest.
“I’ll diversify across index funds.”
And even when investors do understand what’s best, they often don’t follow through.
“I’ll enroll in my 401(k) next month.”
There are easy ways to overcome passivity or exploit it.
Make savings the default or use deadlines to short-circuit procrastination.

Behavioral Finance David Laibson Harvard University

by Micheal77 on Jul 06, 2010

Accessibility

Tags

Upload Details

Usage Rights

1 Embed 1

Statistics

Behavioral Finance David Laibson Harvard University — Presentation Transcript