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!
Prospect Theory
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:
Exercise Tomorrow:
-6 + ½ [8] = -2
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
401(k) participation by tenure at firm
Fraction of employees ever
participated
100%
80%
60%
40%
20%
0%
0
6
12
18
24
30
36
42
Tenure at company (months)
Hired before automatic enrollment
Hired after automatic enrollment ended
Hired during automatic enrollment
48
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.
Distribution of contribution rates
Fraction of participants
80%
67
70%
60%
50%
37
40%
31
30%
26
20
20%
10%
3
18
17
9
6
14
14
10
9
7
6
4
7-10%
11-16%
1
0%
1%
2%
3-5%
6%
Contribution rate
Hired before automatic enrollment
Hired after automatic enrollment ended
Hired during automatic enrollment (2% default)
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 reallocating 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 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!
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!