The Impact of Behavioral Economics on Investor

Decision-Making

Ulrike MalmendierEdward J. and Mollie Arnold Professor of Finance,

Haas School of Business, and Professor of Economics, Department of Economics

University of California, BerkeleyPh.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-)Consistencyo 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 Risko 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 AccountingInvestors 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!

Prospect Theory

Prospect Theoryo 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 FramingWho 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 Managemento 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 Rateso 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 RatesExamples

o Tax refunds

o Salary plans

o Failure to consider life cycle costs

• Copiers

• Credit cards

• Gym membership

Hyperbolic Discounting

Would you like to haveA) $10 now

orB) $11 tomorrow

Would you like to haveC) $10 in a week

orD) $11 in a week and a day

Fruit versus Chocolate

If you were deciding today,would you choosefruit or chocolatefor desert next week?

74%choosefruit

Fruit versus Chocolate

If you were deciding today,would you choosefruit or chocolatefor desert today?

70%choosechocolate

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] = -2Exercise 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.

Findings68% 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 sidewalko 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.

Inertiao 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 Outo Default contribution rateso Default investment allocations

If client has made a decision for an investment (wants to invest!), make implementation the default.

Automatic Enrollment

Automatic Enrollment401(k) participation by tenure at firm

0%

20%

40%

60%

80%

100%

0 6 12 18 24 30 36 42 48

Tenure at company (months)

Fra

ctio

n o

f em

plo

yees

eve

r p

arti

cip

ated

Hired before automatic enrollment Hired during automatic enrollment

Hired after automatic enrollment ended

Automatic Enrollment: Implicationso 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.

Distribution of contribution rates

3

2017

37

149

1

67

7

14

6 469

2631

18

10

0%

10%

20%

30%

40%

50%

60%

70%

80%

1% 2% 3-5% 6% 7-10% 11-16%

Contribution rate

Fra

ctio

n o

f p

arti

cip

ants

Hired before automatic enrollment Hired during automatic enrollment (2% default) Hired after automatic enrollment ended

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 outo Power of Defaults

Example 3: Naïve Diversificationo 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 Diversificationo Investors tend to follow the 1/N rule.o If offered one equity and one debt fund, they

will invest 50-50.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!

Takeawayso 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.”

TakeawaysThere 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!