The McHenry Group
2200 Powell Street
Suite 610
Emeryville, CA 94608
 
Phone: 510-595-2900
Toll free: 800-638-8121
Fax: 510-420-1732
 
info@mchenrygroup.com
 
Additional information may be found at:

www.mchenrygroup.com
 
 

Introduction
 
Until recently, the field of finance ignored human irrationality. Economic theory presumed that individuals had unbiased expectations and acted rationally to maximize their future wealth.[1]
 
But researchers who study financial decision-making have discovered a number of consistent errors in the way people make investment choices. Unbiased, rational wealth-maximizers seem to exist largely in economists’ imaginations.
 
What are the consequences of our increasingly sophisticated understanding of financial behavior for retirement investing and the plan design process? Let’s begin with a discussion of what behavioral finance entails. We can then examine individual investment errors and how to avoid them through appropriate plan design.
 
Behavioral Finance
 
Briefly, behavioral finance combines economics with psychological insights about how people make decisions in order to shed light on market behavior. Researchers have successfully documented a number of circumstances in which investors don’t behave as economic theory would predict. Broadly speaking, the fault lies in what is known as “bounded rationality.”
 
Bounded rationality has two components: 1) constraints on time and information; and 2) limits to our ability to handle complexity. The real world includes all sorts of trade-offs that affect decision-making. We may generally try to optimize our choices, but we do so given limited time and often imperfect information. As a result, we often resort to rules of thumb and other mental shortcuts than can lead to suboptimal outcomes.[2]
 
Further, given complex decisions involving time horizons, competing preferences and an abundance of information, we tend to make systematic errors in judgment. It turns out that humans in general are not particularly good at adequately compounding into the future, or assessing the relative utility of gains today versus future losses, or assigning the appropriate weight to losses.
 
Common Participant Errors
 
Behavioral finance researchers have catalogued a number of systematic errors that affect defined-contribution investment. There is now considerable evidence that plan participants as a whole don’t act to maximize their financial self-interest when it comes to saving for retirement.
 
Let’s briefly examine some of the primary errors in judgment:
 
Inadequate Savings
 
Even when people know that something is in their self-interest, such as saving for retirement, they often find it difficult to act accordingly.[3] We often exhibit a lack of self-control when attempting to forego present enjoyment for future gratification. Further, humans are prone to what’s known as “hyperbolic discounting,” which means that we overemphasize immediate desires and rewards at the expense of long-term needs. People may know that they should save for the future, but things consistently come up in the present that seem more pressing than future needs.[4]
 
In fact, consumption levels closely track income levels throughout people’s lives. We seem to do best with “enforced savings,” such as the equity in our houses and pension plan contributions.[5] In terms of defined contribution plans, aggregate savings rates are abysmal. Twenty-five percent of employees with access to a defined contribution plan don’t contribute at all, and fewer than 10% contribute the maximum amount allowed.[6]
 
Naïve Diversification
 
Rules of thumb and mental shortcuts can cause problems with portfolio diversification, particularly when one lacks knowledge about investing. A common error is to use simple allocation strategies that do not take risk/return preferences into account. This includes the 1/n strategy, where investors simply divide their money equally between all of the fund options available.[7]
 
This is an example of a more general diversification heuristic, in which people make diversification decisions that are influenced by the choices offered them. People’s choices are contextual. That is, they depend a great deal on the circumstances in which decisions are made.
 
Loss Aversion
 
Behavioral finance researchers have also found that people don’t rate gains and losses equally. People tend to accord losses about twice as much weight as gains; that is, losses hurt substantially more than the pleasure that is obtained from a comparable gain. Even people with long-term investing horizons appear to be disproportionately concerned about short-term losses. As a result, people tend to invest using strategies that minimize loss rather than maximize wealth.[8]
 
An extraordinary example comes from Harry Markowitz, the grandfather of modern portfolio theory. He once explained his own investment strategy:
 
"I should have computed the historical covariances of the asset classes and drawn an efficient frontier. Instead, I visualized my grief if the stock market went way up and I wasn’t in it – or if it went way down and I was completely in it…so I split my contributions 50-50 between bonds and equities. I wanted to minimize my future regret."[9]
 
Status Quo Bias
 
Plan participants tend to rebalance infrequently, even when this results in lower overall returns. For example, a study in 1987 found that the median number of changes to TIAA-CREF portfolios over their lifetime was zero. A more recent analysis of TIAA-CREF plans also found that nearly half of the participants never changed their allocation during a ten-year period.[10]
 
Why? Researchers have several theories about the inertia that plan participants exhibit. One is fear of regret. Better not to make a decision than to make an incorrect one. In the case of 401(k) plans, we also have to acknowledge that most people lack the interest or the knowledge to feel comfortable playing an active role in the investment process. They choose to value other ways of spending their time more than they value improving their investing outcome.
 
The Disposition Effect
 
Finally, researchers have found that investors are averse to selling assets at a lower price than the purchase price. Investors are more likely to sell funds that have increased in value than they are likely to sell funds that have decreased in value. This holds true even though tax law favors selling securities at a loss. This is not simply a matter of selling at the right time, because the winners that were sold among the sample data subsequently performed better than the losers that were kept.[11] The issue of regret also plays a role here; selling a security that has done poorly forces the investor to recognize that loss.
 
Further, people evaluate prices by a process known as “anchoring,” in which people’s quantitative estimates are disproportionately based on recent prices. It can be hard for individuals to acknowledge that the higher price is not the “real” price.
 
Plan Design and Behavioral Finance
 
All of these errors in financial reasoning have consequences for plan design, and investment professionals have become increasingly thoughtful about how to better adapt plan features to accommodate human behavior. A behavioral finance approach generally emphasizes automatic and default features that work to circumvent the inadequate saving tendencies of many plan participants. Recommended features include automatic enrollment, automatic rebalancing, default investment options, and automatic increases in deferral rates.
 
Automatic enrollment, which addresses problems of lack of self-control and procrastination, has been quite successful in improving plan participation rates. One program boosted participation rates from 49% to 86%.[12] Default options and automatic rebalancing tackle the problems of inertia and insufficient financial knowledge.
 
Finally, automatic increases in deferral rates improve inadequate savings levels from hyperbolic discounting. It is much easier to get people to agree to future increases in savings rates than to get them to increase savings when the money is actually in their pockets.[13] In one study, automatic increases in deferral rates increased savings levels by almost four times.[14]
 
With these features, plan sponsors can create plans that more closely match the needs of their participants.
 
Conclusion
 
Because financial decision-making errors are systematic, they have to be taken seriously. It’s not just that people don’t always behave rationally – we already knew that. Instead, what matters is that such irrationality is both common and predictable. Inadequate saving, insufficient or inappropriate diversification, and emotional decision-making are all widespread behaviors among defined contribution investors.
 
For anyone who cares about the future financial health of defined-contribution plan participants, common behavioral errors should influence how we think about plan design and oversight.
 
Automation and standardization of the investment process should be the watchwords for plan design. As much as possible, we want to provide effective guidelines for participants to help remove emotion from decision making. As investment professionals, we can make this process more streamlined and straightforward by providing the tools and the guidance to help plan sponsors make the right choices in plan design and execution.