Behavioral Finance and Its Effect on Pension Portfolios

Transcription

1 Behavioral Finance and Its Effect on Pension Portfolios Neil Lloyd, Head of US DC & Financial Wellness Research, Mercer, United States 12 April 2018

2 CONTENT Introduction to Behavioral Finance Impact on Participants (and Fiduciaries) Impact on Investment Managers Summary and Conclusion

3 3 M e r c e r : W h o w e a r e A G LOBAL FORCE OF MORE THAN 21,000 INDIVIDUALS PA S S I O N F O R E N H A N C I N G T H E H E A LT H, W E A LT H, A N D C A R E E R S O F M O R E T H A N 11 0 M I L L I O N P E O P L E W O R L D W I D E U N I T E D B Y A S I N G L E I D E A : T O M A K E L I V E S B E T T E R T O M O R R O W T H R O U G H A C T I O N S W E TA K E T O D AY

4 BEHAVIORAL FINANCE AN INTRODUCTION 4

5 Homo Economicus In theory Investors are FRUMIPET : Free Rational Utility Maximising Individuals, with a given set of Preferences Endowments Trusts In practice 5

6 Shopping for Electronics ipod 20 Minutes ipad

7 Ultimatum Game: One-Time Offer $1,000 Neil decides on division between himself and Lindsey Lindsey accepts Neil's decision Lindsey rejects Neil s decision Neil and Lindsey get what Neil said Neil and Lindsey get nothing

8 Ultimatum Game: $1,000 (A) Neil offers Lindsey $200 (i.e., Neil will keep $800) If you were Lindsey, would you: Accept the offer Reject the offer

9 Ultimatum Game: $1,000 (B) Neil offers Lindsey $450 (i.e., Neil will keep $550) If you were Lindsey, would you: Accept the offer Reject the offer

10 Ultimatum Game: $100,000 (C) Neil offers Lindsey $20,000 (i.e., Neil will keep $80,000) If you were Lindsey, would you: Accept the offer Reject the offer

11 Behavioral Biases L O S S A V E R S I O N H I N D S I G H T C O N F I R M A T I O N B I A S E N D O W M E N T E F F E C T H Y P E R B O L I C D I S C O U N T I N G P R O S P E C T T H E O R Y O V E R C O N F I D E N C E F R A M I N G M E N T A L A C C O U N T I N G D I S P O S I T I O N E F F E C T ANCHORING

12 Endowment Effect Given Pen Given Mug Offered Mug 10% take Mug Offered Pen 12% take Pen Knetsch, Jack L. (1995). Asymmetric valuation of gains and losses and preference order assumptions. Economic Inquiry 38,

13 Overconfidence How would you rate your skills as a fund manager compared to your peers? Above Average Equal to or Below Average Montier, James Behaving Badly. London: Dresdner Kleinwort Wasserstein Securities.

14 Hyperbolic Discounting Which would you choose? A. $100 today B. $105 in a week Which would you choose? A. $100 in a year s time B. $105 in a year and a week

15 Prospect Theory and Loss Aversion People value gains and losses differently, and will make decisions on perceived gains rather than perceived losses Investors sell winners too quickly and keep losers too long

16 Impact of Behavioral Finance in Pensions Participant decisionmaking Fiduciary decisionmaking Investment management Advisors, providers, or other technical experts

17 BEHAVIORAL FINANCE IMPACT ON PARTICIPANTS (AND FIDUCIARIES) 17

18 Pro-default: Inertia Newton's first law of motion: Inertia Auto-enrollment, target date funds, auto-escalation

19 Status Quo Bias + Hyperbolic Discounting Save More Tomorrow 78% of participants given access to Save More Tomorrow adopted it 80% of participants were still in the program after their fourth pay raise Average participant contributions nearly quadrupled from 3.5% to 13.6% in three years Benartzi, Shlomo and Richard Thaler (2004), Save More Tomorrow : Using Behavioral Economics to Increase Employee Saving, Journal of Political Economy 112 (S1): S164-S187.

20 Anchoring and Framing Which contribution rate would you like to enroll at? 12% 8% 10% 6% 4% 8%

21 More Framing Participants asked to select an investment mix given 2 fund options Group 1 Group 2 Group 3 Choice between two funds equity fund bond fund equity fund balanced fund bond fund balanced fund Average equity allocation 54% 74% 35% A common strategy was to choose a 50/50 mix of the two funds offered Benartzi, Shlomo, and Thaler, Richard H., 2001, Naïve Diversification Strategies in Defined Contribution Saving Plans, American Economic Review 91 (1),

22 How Do Retirees Think About Risk/Return? PERSONAL RISK : Protective Assets. Goal: Do Not Jeopardize Standard of Living MARKET RISK : Market Assets. Goal: Maintain Lifestyle, Grow in Line With Wealth Segment ASPIRATIONAL RISK : Aspirational Assets. Goal: Enhance Lifestyle, Increase Wealth Relative to Others Chhabra, A.B., (2005), Beyond Markowitz: A Comprehensive Wealth Allocation Framework for Individual Investors, Journal of Wealth Management, 7(4), pp 8-34.

23 Wealth Effect we also estimate that automatic enrollment raises auto and first mortgage debt at three to four years of tenure Borrowing to Save? The Impact of Automatic Enrollment on Debt, John Beshears Harvard University and NBER, James J. Choi Yale University and NBER, David Laibson Harvard University and NBER, Brigitte C. Madrian Harvard University and NBER, William L. Skimmyhorn United States Military Academy The perceived increase in wealth from compulsory contributions, growing superannuation balances and rising house prices has persuaded people to use debt to fund a current higher standard of living. Twenty years of the Superannuation Guarantee : The Verdict, CPA Australia, August 2013

24 International Differences in Investor Patience Most patient Meta, Renisa. (2015). Behavioral Finance: The Psychology of Investing. Based on Study by Professor Dr. Mei Wang, Professor Dr. Marc Oliver Rieger, and Professor Dr. Thorsten (2010)

25 International Differences in Investor Loss Aversion Most tolerant of loss Meta, Renisa. (2015). Behavioral Finance: The Psychology of Investing. Based on Study by Professor Dr. Mei Wang, Professor Dr. Marc Oliver Rieger, and Professor Dr. Thorsten (2010)

26 Inclination to Bet on Extremely Unlikely Events with a Very Positive Outcome High inclination Meta, Renisa. (2015). Behavioral Finance: The Psychology of Investing. Based on Study by Professor Dr. Mei Wang, Professor Dr. Marc Oliver Rieger, and Professor Dr. Thorsten (2010) Meta, Renisa. (2015). Behavioral Finance: The Psychology of Investing. Based on Study by Professor Dr. Mei Wang, Professor Dr. Marc Oliver Rieger, and Professor Dr. Thorsten (2010)

27 BEHAVIORAL FINANCE IMPACT ON INVESTMENT MANAGERS 27

28 Are Behavioral Problems New to the Investment World? Tulipmania in Holland in the 1630s

29 Behavioral Problems Continue Today (Overconfidence) Portfolio turnover and return Mean monthly turnover Average annual portfolio return 20% least active traders 20% most active traders 0.19% 18.5% 21.49% 11.4% Brad Barber and Terrence Odean (1999) The courage of misguided convictions. Financial Analysts Journal, November/December, p. 50.

30 Low Volatility Equity Strategies? Risk/Return Tradeoff Return Lower risk exposure Lower expected return Higher risk exposure Higher expected return Risk

31 Low Volatility Equity Strategies? MSCI World Ave Monthly Return (Geo) 0.71% 0.95% MSCI World Minimum Volatility 225 Std Deviation (Monthly returns) 14.4% 10.5% Low volatility equities have a greater ability to protect capital in falling markets 25 MSCI World MSCI World Minimum Volatility

32 How Can We Address our Irrationality To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insight, or inside information. What is needed is a sound intellectual framework for decisions and the ability to keep emotions from corroding that framework. -Warren Buffett 32

33 Understand Biases : An Analytical Approach By analyzing trades, can quantify behavioral biases Where do you add value selling or buying? Which sells work best? Which buys work best? How do your PMs differ? Portfolios engaged in deliberate improvement are, on average, adding approximately 45 basis points of incremental relative return year after year 1 1 Based on a study of over 80 professionally managed portfolios across a five-year timeframe. For more information see: "Improving Deliberately with Cabot", available from Cabot Research LLC

34 One Example Buys shares with 50% upside and 33% downside If share appreciates 50% If share falls 33% Sell one third Refer to a new analyst

35 BEHAVIORAL FINANCE SUMMARY AND CONCLUSION 35

36 Individuals Investment managers Behavioral science (or finance) pervades pensions Fiduciaries

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