Behavioral Finance:
Investment mistakes and solutions
David Laibson
Professor of Economics
Harvard University
National Bureau of Economic Research
June, 2009
Mainstream economics
Standard (or “classical”) assumptions:
 People know what’s in their best interest.
 And they act on that knowledge.
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
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:
Personal finance:
• IPO timing
• Winner’s curse
• Cash-flow sensitivity
• Overconfidence
• Superstar CEO’s
•
•
•
•
•
•
•
•
•
•
Procrastination
Emotional choice
Loss aversion
Narrow Framing
Return chasing
Passivity
Financial illiteracy
Home bias
Overconfidence
Wishful thinking
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
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
6
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
Madrian and Shea (2001)
Choi, Laibson, Madrian, Metrick (2004)
401(k) participation by tenure at firm
100%
Automatic
enrollment
80%
60%
Standard
enrollment
40%
20%
0%
0
6
12
18
24
30
36
Tenure at company (months)
42
48
Employees enrolled under automatic enrollment
cluster at default contribution rate.
Fraction of Participants at different contribution rates:
Default contribution
rate under automatic
enrollment
67%
37%
20%
7%
3% 1%
1%
17%
2%
3%–5%
14%
14%
6%
6%
7%–10%
Contribution Rate
Before Auto Enrollment
After Auto Enrollment
9%
4%
11%–16%
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.
10
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
401(k) participation increases under
active decisions
401(k) participation by tenure
100%
Active decision
80%
Standard enrollment
60%
40%
20%
0%
0
6
12
18
24
30
Tenure at company (months)
36
42
48
54
Third Solution
Simplification
Fraction Ever Participating in Plan
Beshears, Choi, Laibson, Madrian (2006)
50%
2005
2004
40%
30%
2003
20%
10%
0%
0
3
6
9
12 15 18 21 24 27 30 33
Time since baseline (months)
13
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%
14
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
15
Data from Harvard Staff
$581
$516
Control Treatment
$518
$451
$385
$320
$255
16
3% of Harvard staff
in Control Treatment
put all $$$
in low-cost fund
Fees salient
$494
Fees from
random
allocation
$431
Data from Harvard Staff
$581
$516
Control Treatment
$518
$451
Fees salient
$494
$385
$320
$255
17
3% of Harvard staff
in Control Treatment
put all $$$
in low-cost fund
9% of Harvard staff
in Fee Treatment
put all $$$
in low-cost fund
Fees from
random
allocation
$431
$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
18
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
Two other psychological biases that are
particularly important in the aftermath of
the financial crisis
1. Return chasing
2. Narrow framing
20
Return chasing in 401(k)’s
 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
21
Households are otherwise being
relatively passive:
 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
22
Passivity and return chasing work
together to produce reallocations:
 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
23
Source: Hewitt Associates and author’s calculations.
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)
+100,000 DB pension
+300,000 home
+200,000 Social Security claim
+300,000 NPV labor income
24
50% equities
33% equities
16% equities
12% equities
9% equities
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
0.84
0.80
1952.1
1953.4
1955.3
1957.2
1959.1
1960.4
1962.3
1964.2
1966.1
1967.4
1969.3
1971.2
1973.1
1974.4
1976.3
1978.2
1980.1
1981.4
1983.3
1985.2
1987.1
1988.4
1990.3
1992.2
1994.1
1995.4
1997.3
1999.2
2001.1
2002.4
2004.3
2006.2
2008.1
Total consumption (C+G) over GDP
US NIPA 1952:1 to 2009:1
0.92
2009:1
0.90
0.88
0.86
1998.1
0.82