Behavioral Finance Laibson

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Behavioral Finance

David LaibsonRobert I. Goldman Professor of Economics

Harvard College Professor

Harvard University

National Bureau of Economic Research

November 17, 2008


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Mainstream economics

Standard (or classical) assumptions:

People knowwhats in their best interest.

And they act on that knowledge.


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Behavioral Economicsalso known as

Psychology and Economics

Better assumptions:

People sometimes get confused.

International equities make my portfolio more risky.

And even when we do understand whats best, weoften dont follow through.

Ill diversify my portfolio next month.

Psychology + Economics

Nobel Prize (2002) to Daniel Kahneman


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Behavioral FinanceUse psychology and economics to understand finance:

Asset pricing:

Price Anomalies

Value Anomaly

IPOunderperformance

Equity premium

PEA drift

Momentum

Bubbles

Corporate finance:

IPO timing

Winners curse

Cash-flow sensitivity Overconfidence

Superstar CEOs

Household finance:

Present Bias Passivity Procrastination Financial illiteracy

Emotional choice

Return chasing Loss aversion

Narrow Framing

Home bias

Overconfidence

Wishful thinking


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Thought Experiment

Would you like to have

A) 15 minute Swedish massagenow

or

B) 20 minute Swedish massagein an hour

Would you like to have

C) 15 minute Swedish massagein a week

or

D) 20 minute Swedish massagein a week and an hour


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Choosing fruit vs. chocolateRead and van Leeuwen (1998)

Time

Choosing Today Eating Next Week

If you were

decidingtoday,

would you choose

fruit or chocolate

fornext week?


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Patient choices for the future:

Time

Choosing Today Eating Next Week

Today, subjects

typically choose

fruit fornext week.

74%choose

fruit


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Impatient choices for today:

Time

Choosing and EatingSimultaneously

If you were

decidingtoday,

would you choose

fruit or chocolate

fortoday?


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Time Inconsistent Preferences:

Time

Choosing and EatingSimultaneously

70%

choose

chocolate


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The desire for instant gratificationRead, Loewenstein & Kalyanaraman (1999)

Choose among 24 movie videos

Some are low brow: Four Weddings and a Funeral

Some are high brow:

Schindlers List

Picking for tonight: 66% of subjects choose low brow.

Picking for next Monday: 37% choose low brow.

Picking for second Monday: 29% choose low brow.

Tonight I want to have funnext week I want things that are good for me.


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Quantitative Model

Quasi-hyperbolic discounting (Laibson, 1997)

Place full weight on present rewards and costs

Place half weight on all future rewards and costs


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ProcrastinationAkerlof 1991

Suppose that smoking has an immediate benefit of 6 anddelayed health cost of 8.

Will you smoke today?

Smoke Today: 6 + [-8] = 2

Smoke Tomorrow: 0 + [6 - 8] = -1

Happy to make plans today to quit tomorrow. But likely to fail to follow through.

Same pattern for smoking, diet, exercise, savings, etc.


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Joining a GymDella Vigna and Malmendier (2004)

Average cost of gym membership: $75 per month

Average number of visits: 4

Average cost per visit: $19

Cost of pay per visit: $10


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Procrastination in retirement savingsChoi, Laibson, Madrian, Metrick (2002)

Survey

Mailed to a random sample of employees

Matched to administrative data on actual savings behavior


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Typical breakdown among 100 employees

Out ofevery 100surveyedemployees

68 self-reportsaving too little 24 plan to

raise

savings ratein next 2months

3 actually follow through


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The power of deadlines: Active decisions

Choi, Laibson, Madrian, Metrick (2004)

Active decision mechanisms require employees tomake an active choice about 401(k) participation.

Welcome to the companyYou are required to submit this form within 30 days of

hire, regardless of your 401(k) participation choice

If you dont want to participate, indicate that decision

If you want to participate, indicate your contributionrate and asset allocation

Being passive is not an option


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401(k) participation increases underactive decisions

401(k) participation by tenure

0%

20%

40%

60%

80%

100%

0 6 12 18 24 30 36 42 48 54

Tenure at company (months)

Active decision

Standard enrollment


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Active decisions: conclusions

Active decision raises 401(k) participation.

Active decision raises average savings rate by 50percent.

Active decision doesnt induce choice clustering.

Under active decision, employees choose savingsrates that they otherwise would have taken three yearsto achieve. (Average level as well as theentiremultivariate covariance structure.)

What could you do? Ask service members to make anactive choice.


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0%

10%

20%

30%

40%

50%

0 3 6 9 12 15 18 21 24 27 30 33

Time since baseline (months)

Fraction

EverParticipating

in

Plan

2003

2004

2005

Simplified enrollment raises participationBeshears, Choi, Laibson, Madrian (2006)


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Automatic enrollmentThe future of the TSP?

Welcome to the uniformed services

If you dont do anything

You are automatically enrolled in the TSP

You automatically contribute 3% of your pay

Your contributions go into the G fund

Call this phone number to opt out of enrollmentor change your investment allocations


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Madrian and Shea (2001)Choi, Laibson, Madrian, Metrick (2004)

401(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)

Automatic

enrollment

Standard

enrollment


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3%

20%17%

37%

14%9%

1%

67%

7%14%

6% 4%

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

Contribution Rate

Before Auto Enrollment After Auto Enrollment

Employees enrolled under automatic enrollmentcluster at default contribution rate.

Fraction of Participants at different contribution rates:

Defaultcontributionrate underautomatic

enrollment


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Participants stay at the automatic enrollmentdefaults for a long time.

0%

20%

40%

60%

80%

100%

0 6 12 18 24 30 36 42 48

Fraction of Participants Hired Under Automatic Enrollmentwho are still at both Default Contribution Rate and Asset Allocation

Company B

Company C

Company D

Frac

tion

ofParticipa

nts

Tenure at Company (Months)


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Automatic enrollment

Participants hired under automatic enrollment tend tostay at the automatic enrollment defaults (about 75%)

Default saving rates

Default asset allocationAutomatic enrollment results suggest that employees

are passive


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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

When workers need to make active decisions, 70% jointhe 401(k) plan in the first three months of work

Opt-out rates underautomatic enrollment are typicallyonly 15% (opt-out rates rarely exceed 20%)

Underautomatic enrollment (and even asset mapping)HR offices report no complaints in 401(k) plans

97% of employees in auto-enrollment firms approve ofauto-enrollment.

Even among workers who opt out, approval is 79%.


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Looking ahead

If the TSP does adopt automatic enrollment with a 3%saving rate and automatic asset allocation to the Gfund, I recommend that you:

Nudge service members to choose a higher savings

rate (e.g., 10% of their income)

Nudge service members to choose a more aggressive

asset allocation (e.g., Lifecycle fund)


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Emotional Decision-makingShiv and Fedorikhin (1999)

Cognitive burden/load is manipulated by havingsubjects keep a 2-digit or 7-digit number in mindas they walk from one room to another

On the way, subjects are given a choice between

a piece of cake or a fruit-salad

Processing burden % choosing cake

Low (remember only 2 digits) 41%

High (remember 7 digits) 63%


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Emotional system (dopaminergic targets)vs. Fronto-Parietal System

DopaminergicReward System(Affective/emotional)

Frontalcortex

Parietalcortex


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Emotional system responds only to immediate rewards

y = 8mmx = -4mm z = -4mm

0

7

T13

d = Earliest reward available todayd = Earliest reward available in 2 weeks

d = Earliest reward available in 1 month

VStr MOFC MPFC PCC

Neuralactivity

Seconds

McClure, Laibson, Loewenstein, and CohenScience (2004)

0.4%

2s


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30

x = 44mm

x = 0mm

0 15T13

VCtx

0.4%

2s

RPar

DLPFC VLPFC LOFC

Analytic brain responds equally to all rewards

PMA

d = Earliest reward available in 2 weeks

d = Earliest reward available in 1 month

d = Earliest reward available today


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0.0

-0.05

0.05

Choose

Smaller

Immediate

Reward

Choose

Larger

Delayed

Reward

Emotional

System

Frontal

system

BrainActivity

Brain Activity in the Frontal System andEmotional System Predict Behavior

(Data for choices with an immediate option.)


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Conclusions of fMRI study

Time discounting results from the combined influence oftwo neural systems:

Emotional limbic system is impatient

Analytic fronto-parietal system is patient.

Emotional brain, responds little to delayed rewards Emotional brain engenders taste for instant gratification

Financial education:


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Financial education:

Choi, Laibson, Madrian, Metrick (2004)

Seminars presented by professional financialadvisors

Curriculum: Setting savings goals, asset allocation,

managing credit and debt, insurance againstfinancial risks

Seminars offered throughout 2000

Linked data on individual employees seminar

attendance to administrative data on actual savingsbehavior before and after seminar


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Effect of education is positive but small

Seminar attendeesNon-

attendees

% planningto makechange

% actuallymade

change

% actuallymade

change

Those not in 401(k) plan

Enroll in 401(k) Plan 100% 14% 7%

Those already in 401(k) plan

Increase contribution rate 28% 8% 5%Change fund selection 47% 15% 10%Change asset allocation 36% 10% 6%


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Summary

Present bias: current rewards get full weight whilefuture rewards get half weight.

Self-defeating behaviors and retirement savings

Practical solutions that overcome passivity or exploit it.

1. Ask people to make an active choice

2. Simplify enrollment3. Use automaticity

Behavioral Finance Laibson

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