Behavioral economics is making a serious impact on the way people approach lots of decisions. Gone is the classic view of humans as rational decision makers who will always do the logical thing if presented with solid information. We've known better for years. Now a growing body of economic thought is providing a research-based foundation for our common sense.
In retirement circles, a big victory for behavioral thinking occurred a few years ago when the default rules for employment-based 401(k) plans changed. Too few employees were opting to sign up for the plans, and those who did often made uninformed investment decisions.
The changes enrolled all employees in the plans by default and required those who did not wish to join to opt out. Participation rates jumped. Plan administrators also were empowered to put participants in default investments that pursued appropriate risk and diversification objectives. Employees could always opt out, into their own investment choices. Again, many employees stayed with the default choices, and their portfolios are the better off because of it.
Now, a recent report points the way to improved behavioral approaches to four persistent problems that plague individual investors. The report was written by UCLA professor Shlomo Benartzi, who also is the chief behavioral economist for Allianz Global Investors Center for Behavioral Finance, which issued the white paper.
In a condensed history of behavioral economics, Benartzi focuses on the clashes between our intuitive and reflective minds. "Most decisions that people make are products of the intuitive mind, and they are usually accepted as valid by the reflective mind, unless they are blatantly wrong," he writes, citing the research of other economists. Intuitive decisions, however, are particularly hard to override because we feel so strongly that they're correct.
The intuitive mind is more fearful of losses than it is pleased by gains. This loss aversion drives investors to hold onto losing investments too long and sell winning investments too soon. It can also lead to selling stocks when markets are near the bottom of an investment cycle, and not buying back in until prices are near cyclical peaks. The way the intuitive mind evaluates losses can also be a powerful force in leading to other poor investment decisions. In particular, it seeks a reference point for evaluating gains and losses and may stubbornly cling to such notions even in the face of contrary evidence.
Lastly, our intuitive approach to decision-making causes us to avoid solid planning. We favor satisfying decisions that lead to current enjoyment at the expense of future benefits. And when things do turn out poorly, we lose so much confidence and faith in a process that we avoid making decisions even though our reflective minds may see the value in doing so.
Benartzi's white paper weaves these behavioral traits into four specific investment problems, and how they are being addressed by Allianz financial advisers and investment clients:
1. Overcoming investor paralysis. The market collapse of 2008-2009 has made investors reluctant to reinvest in the market, even as stock prices have recovered all of the ground they've lost. The behavioral solution is similar to the 401(k) changes, but the goal is not to save more for the future—it is to invest more for the future.
To overcome fear of loss and inertia, the program is oriented to future decisions, which takes a lot of heat off the intuitive mind and lets the reflective mind be more influential. To minimize concern over losses, added investments are not made at one time, but in a sequence of predetermined steps. "There is no single figure against which to measure performance," Benartzi says. "In which case, loss aversion is much less likely to kick in."
2. Reining in lack of investor discipline. The goal here is to reduce intuitive investment mistakes—poorly informed choices and timing decisions—by creating a plan today that can be shaped by the reflective mind and won't be implemented until a future date. Time shifting is a key to countering intuitive investment impulses, the report stresses: "Financial advisers could invite their clients to engage their reflective mind to pre-commit to a rational investment strategy in advance of movements of the market that might otherwise trigger irrational responses of the intuitive mind."
This strategy should be written down and agreed to by the investor and the adviser. Future changes in investment behavior would likewise have to be formalized and agreed to. If you don't have an investment adviser, Benartzi says in an interview, work with your spouse or a friend. The key requirement is that your investment plan must be formalized and written down, and should include contingencies. What will you do if the rate of inflation increases substantially, or if the U.S. economy slips back into recession? The reflective mind is good at doing this kind of work. The requirement to put it in writing uses behavioral tools so that people's inertia works in their favor, not against them.
3. Regaining and maintaining trust. This problem, as laid out in the paper, involves investors' loss of trust in their financial advisers following the market collapse. Mirroring the intuitive-reflective nature of how we evaluate things, Benartzi lays out steps advisers can take to deal with trust issues stemming from fears about adviser competence (the reflective mind) and lack of empathy between investors and advisers (the intuitive mind). The paper does not address broader issues of investor lack of trust in the investment markets themselves. But for investors who do not have advisers, there may be value in using similar approaches.
4. The disinclination to save. Beyond investment planning and prowess, the deep recession made it painfully clear that most Americans need to be saving a lot more money for retirement. Grappling with this problem has produced what may become Allianz's most creative application of behavioral economics—The Behavioral Time Machine. It is based on research that Benartzi credits to Hal Ersner-Hershfield (Northwestern University) and Daniel L. Goldstein (Yahoo Research and the London Business School).
Saving for retirement, it turns out, is strongly affected by a disconnect between our current and future selves. In effect, the paper quotes Ersner-Hershfield as saying, "saving for retirement may feel to the present self like giving money to a stranger years into the future." The Time Machine that Allianz is developing will use aging simulation software to allow people to create future images of themselves. It then will create different futures for those individuals based on current savings decisions. And when those futures change, so will the expressions on the faces of participants' future selves. Behavioral researchers have found that people who can better relate to future versions of themselves are much more likely to set aside savings today, Benartzi notes. And if they also could see the emotional impact on their future selves of different savings choices, the amount of current savings increased even more.
The intuitive mind creates a strong emotional bond between present and future selves, and the reflective mind endorses that relationship and supports an enhanced savings program. "I think this is more of an emotional engagement tool, which I think is very, very clever," Benartzi says. "Right now, the decision of how much to save is done in a vacuum. It's just numbers."