Investor Psychology Important for Retirement Planning
December 22, 2003
WASHINGTON - A judicious dose of investor psychology could mean a big difference in marketing retirement products.
Daniel Kahneman, a psychology professor from Princeton University, Princeton, N.J., provided some insight into investors' decision-making process here at the annual meeting of the National Association for Variable Annuities of Reston, Va.
Kahneman, a Nobel laureate in economic sciences, described how human nature often defies logic in influencing financial decisions -- as well as how to counteract this effect.
"How you represent the problem does have an effect on people's preferences and choices," he said.
For some reason, "people can understand games of chance and sports statistics, not problems related to specific events," Kahneman explained. This fact potentially plays an important role in helping investors understand the relative likelihood of different financial scenarios and matching that with their risk tolerance.
One concept Kahneman explained was that of "anchoring." This is the tendency for people to be strongly influenced by a particular number, regardless of its relevance to real probability.
Part of the problem is conceptual. "Numbers that come to mind are a value, not a distribution. In reality, probability is a distribution," Kahneman said.
Research has demonstrated that people are terrible at estimating very likely or very unlikely outcomes in the stock market. When asked to guess values of a stock index like the S&P 500 that are 99% likely to be either too high or too low, people typically generate a number that is only 80% to 85% likely to occur.
"Subjectively, the numbers are unrealistically narrow," Kahneman said. This says two things about how people view the stock market. First, they don't keep track. Second, "people are less surprised than they ought to be because of hindsight. Later, they will lie to you about how probable they thought the event was," Kahneman explained.
What does all this mean in the context of financial planning? "Getting people to understand uncertainty is an uphill battle," Kahneman said, because "Anchoring causes you to underestimate the amount of uncertainty."
Therefore, advisers should delay mentioning such numbers as long as possible since they probably can't get away with not mentioning them at all. It's important for them to keep in mind that statistics are less clear than people generally think and that people who select their own investments are grossly overoptimistic about the outcomes.
This last point was demonstrated in a study by Terrance Odean, associate professor in the Haas Finance Group at Stanford University in Stanford, Calif. In a paper published in the Journal of Finance in April, 2000, Odean and co-author Brad Barber, a finance professor at the Graduate School of Management at the University of California at Davis in Davis, Calif., presented evidence that self-directed investors at a discount brokerage who traded more underperformed the market.
In the study, the most frequent traders averaged 11.4% returns while the market returned 17.9% overall. The average return among all such accounts was 6.4%, with an annual turnover of 75%.
Kahneman also pointed out that there is a gender difference in self-directed investing, based on the fact that women are not as affected by overconfidence in their investing ideas. They generally make better investors, Kahneman said, explaining, "They don't pick better stocks; they just [trade] less."
Defer to the Default
Another important implication of anchoring is the use of defaults. The same way that numbers generate overconfidence, default selections and values also create inertia, where people simply defer to the default.
For example, in Europe, in countries where organ donation is the default, 94% of the population elects to become organ donors. Where it is not the default, only 18% elect to become organ donors.
"When we propose the default, it has an enormous influence over what people do," Kahneman said, so defaults can be used as a tool to help investors make wiser choices and avoid some of the pitfalls of overconfidence.
Defaults could be used to investors' benefit in defined contribution plans, where many people do not save as much as they could. Richard Thaler, professor of behavioral science and economics at the Graduate School of Business at the University of Chicago, and Shlomo Benartzi, associate professor of accounting at the Anderson School of Management at the University of California in Los Angeles, have studied how defaults can help employees save more.
By having a default that increases employees' savings rate at their next pay raise by 3%, Thaler and Benartzi discovered that savings rose from 3% to 11% in a little over three years. Employees were allowed to opt out of the increase at any time, but they tended to continue increasing the savings rate because it was automatic.
"If you know people are going to be irrational, how do you get them to do what is in their best interest?" Kahneman asked. "Offer a sensible default."
Another way of helping investors make better decisions is by framing the problem in a way that best represents the real risk. While people have a tendency of considering their decisions using a narrower view of the issue, the broader view is often more representative.
For example, most people would reject a gamble based on a 50% chance to win $15,000 or a 50% chance to lose $10,000. However, most people would accept that gamble recast as a 50% chance to increase wealth by $15,000 or a 50% chance to decrease wealth by $10,000.
In presenting information to help people make financial decisions, marketers need to carefully consider how they are influencing people's decisions because there is no unbiased or neutral way to do so. For instance, by citing a figure, are they anchoring the investor on a typical case or the worst case?
Ultimately, advisers are hoping to help people, so marketing materials should be created to do just that. Kahneman summed it up: "People need help in adopting a comprehensive view of financial plans."
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