2-1.9. Bottom Line on Biases in Investment Decisions

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En provenance du cours de University of Illinois at Urbana-Champaign

Investments II: Lessons and Applications for Investors

223 notes

University of Illinois at Urbana-Champaign

Investments II: Lessons and Applications for Investors

223 notes

Cours 4 sur 7 dans Specialization Financial Management

In this course, you will start by reviewing the fundamentals of investments, including the trading off of return and risk when forming a portfolio, asset pricing models such as the Capital Asset Pricing Model (CAPM) and the 3-Factor Model, and the efficient market hypothesis. You will be introduced to the two components of stock returns – dividends and capital gains – and will learn how each are taxed and the incentives provided to investors from a realization-based capital gains tax. You will examine the investment decisions (and behavioral biases) of participants in defined-contribution (DC) pension plans like 401(k) plans in the U.S. and will learn about the evidence regarding the performance of individual investors in their stock portfolios. The course concludes by discussing the evidence regarding the performance of actively-managed mutual funds. You will learn about the fees charged to investors by mutual funds and the evidence regarding the relation between fees charged and fund performance. Segments of the portfolios of mutual funds that may be more likely to outperform and examples of strategies designed to “earn alpha” will also be introduced. Learners are welcome to take this course even if they have not completed "Investments I: Fundamentals of Performance Evaluation," as the first module contain a review of investment fundamentals and regression analysis to get everyone up to speed. Also, the course contains several innovative features, including creative out-of-the-studio introductions followed by quick-hitting "Module in 60" countdowns that highlight what will be covered in each module, four "Faculty Focus" interview episodes with leading professors in finance, and a summary of each module done with the help of animations! This course is part of the iMBA offered by the University of Illinois, a flexible, fully-accredited online MBA at an incredibly competitive price. For more information, please see the Resource page in this course and onlinemba.illinois.edu.

À partir de la leçon

Module 2: Investment Decisions in DC Pension Plans

In Module 2, we discuss the investment decisions of participants in defined-contribution (DC) pension plans like 401(k) plans in the U.S. Not falling prey to common behavioral biases is key to sound financial decision-making in these retirement plans, so we will discuss common behavioral biases of DC pension plan participants.

2-1.1. Overview of Key Biases in Decisions9:32

2-1.2. Representativeness4:29

2-1.3. Familiarity Bias and Background Risk22:22

2-1.4. Endorsement Effects7:27

2-1.5. Naïve Diversification18:47

2-1.6. Inertia4:58

2-1.7. Option Confusion5:36

2-1.8. Power of Defaults16:19

2-1.9. Bottom Line on Biases in Investment Decisions7:53

Rencontrer les enseignants

Scott Weisbenner
William G. Karnes Professor of Finance
Department of Finance, College of Business

[MUSIC]

Can you believe it?

We're almost done with module two, so let me just wrap up with a bottom line and

some of the biases that have been found in 401(k) plans.

First, as just kind of background, it's not that surprising that there's a lot of

behavioral biases surfacing in 401(k) vesting.

After all, it's Democratization of investing.

A lot of people making complicated choices for the first time.

So it's not surprising that there can be some psychological factors

that play into that.

What are a few things we've kind of learned from the research?

Plan design is very important and it can influence participants in ways

that you kind of rational model wouldn't predict.

Remember effects, such as endorsement effect, naive diversification.

So how the plan is structured can have big

effects on how people make investment decisions.

Defaults are powerful, but be careful with the power.

We know because of inertia,

the initial track you have a participant on, are they saving?

Are they not?

Are they in a balanced fund, a lifecycle fund, target date fund, or

are they in a money market fund?

A rational economist viewpoint would be like, you can change these decisions.

But we know given inertia, people rarely do, so

that initial decision is crucially important.

If you have a default, you want to have a default that something that's suitable for

a good share of people and also think about whether the biases or

the people who design the plan and select the funds in the plan.

We're talking a lot about the participants, but

how about the people who set the plan up?

That select the funds?

That select what the default is?

Is it default you're in the plan or out of the plan?

What 's the default investment allocation?

How many funds are there?

What are the incentives of the people who make those decision is also very

interesting question?

So how are individuals doing in their defined contribution pension plans?

We talked about some of these biases, what happens when we just actually look,

what are the investment decisions people are making?

And it's interesting to provide a time series perspective on this.

So lets look at asset allocation decisions of new hires from 1998 to 2011.

So here is some data and this is done or

provided by EBRI, Employee Benefit Research Institute and

we're going to look at two points in times, 1998 and 2012.

And this is look at firms,

we're looking at firms that have company stock as an investment option.

So among those firms that have company stock as an investment option,

what do we see in terms of the investment allocations?

New hires in 1998.

Well, we see companies stock average allocations about almost 25%.

Stock allocations over 50%.

So if you add this together, that's almost 80% in equities,

percent in balance funds under 10%.

So you might look and say,

I may be concerned as a policy maker that like these are pretty aggressive choices.

Like equity allocations,

maybe that's influenced by a lot of equity options in the plant.

Company stock, we talked about familiarity bias.

So this might raise some concern right, because for every Microsoft and Google,

there's an Enron and United Airlines in this high company stock exposure

could put some participant's retirement wealth at risk.

Now, let's fast forward to 2011.

So the black bars are 1988.

The grey bars are 2011, dramatic change.

So what are a few of the key ones?

The amount going into balance funds has increased dramatically from

under 10% to over, let's say, about 35%.

The amount going into company stock by new hires has

fallen dramatically from roughly 25% to 10%.

Also, the amount going into equities has fallen, as well.

So more money into balanced funds that have a mix of stocks and bonds.

A lot of these funds will change that mix as you age,

as you get closer to retirement.

They'll back off the equity allocation less money in company stock.

So if you take a snapshot of people investing in 2011,

you would say, well, this seems like pretty reasonable choices here.

Another way to just show this is the percent of recent hires that invest in

balance funds is increased dramatically from about 30% to almost 70% while those

that are investing in their own firm's stock has fallen from 60% to on the order

of like 30% here among the plans that have kind of have company stock as an option.

So big effect on how people behave.

So what's going on here?

Why do we have this big change in portfolios of these individuals?

Well, I think a big part of this,

is the change in the retirement plan landscape with the use of default options.

And remember, what since 2006, what's a very popular default option?

It's a balance fund or called life cycle fund, or target day fund.

So a lot of the change in behavior is reflecting people not making choices and

new hires today increasingly having the choice made,

because the default policy is, you're saving and

you're saving in a balance fund at an increasing share of firms.

So remember, government regulations in the late 90s, early 2000s,

allowed firms to auto enroll employees.

They can always opt out, if they wish.

Also, kind of the Pension Protection Act change how you can firms.

What they can set as a default, set as balance funds.

The best choice for a lot of workers may turn out to be

no choice in terms of having this diversified balance portfolio.

So stay tuned, I know that it seems like module two is done, but

we're going to launch our inaugural episode of our faculty focus series and

I'm very proud of this logo with the magnifying glass here.

And Stephen Colbert on his first late night episode brought in George Clooney,

you bring in the big gun.

Who am I bringing in for my first inaugural episode?

Dean Jeff Brown here.

So our conversation's going to be focused on annuities.

So annuities are a product that you get to retirement, you have a stock, a wealth.

Maybe it's 1 million, 2 million, who knows?

$5 million.

How do you spend that down in retirement?

An annuity is a product that can help you to kind of spend your money in retirement

and the key thing with annuity is it allows you to not have to worry about

outliving, you're outliving your wealth,

because one of the key things you don't know is, is how long are you going to

live, makes it very hard to plan kind of your retirement spending.

If you have an annuity,

it's an insurance product that basically insures against you living a long time.

In this case, you're buying insurance for something good.

I want to live a long time, but you would love to have a product that can

insure you have enough money to do so and annuity can do that for you.

So in our faculty focus episode with Jeff Brown,

we'll be talking about the pros and cons of annuities.

So be sure and stay tuned for that.

[SOUND]

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