Journal of Financial Planning: January 2018
Harold Evensky, CFP®, AIF®, is chairman of Evensky & Katz/Foldes Financial in Coral Gables, Florida, and Lubbock, Texas. He frequently speaks on investment and financial planning issues, and is author of Wealth Management and co-editor of The Investment Think Tank.
Michael A. Guillemette, Ph.D., CFP®, is an assistant professor in the Department of Personal Financial Planning at Texas Tech University. His publications, which focus on risk and insurance, have been featured in the Wall Street Journal, CNBC, and Bloomberg. He has been invited to speak about his research to FPA chapters across the country.
This installment of the Journal’s research column is quite different than the traditional “what’s of interest recently.” My guest columnist, Professor Michael Guillemette, Ph.D., CFP®, suggested that in honor of the recent award of the Nobel Prize to Richard Thaler, a professor at the University of Chicago Booth School of Business, it would be appropriate to reflect on his work; specifically, how Thaler’s work impacts financial planning. I thought that was a terrific idea. So, I introduce you to a most interesting contribution by professor Guillemette. Enjoy. – H.E.
Richard thaler, who is arguably the father of behavioral economics, recently won the Nobel Memorial Prize in Economic Sciences. Prior to the 1980s, almost all economists assumed that people were rational actors. The significance of Thaler’s work stems from the idea that people are less rational than assumed, and that psychology may influence human behavior in predictable ways. What follows is an overview of some of Thaler’s research findings and applications to the field of financial planning.
“Myopic Loss Aversion and the Equity Premium Puzzle” by Shlomo Benartzi and Richard Thaler (The Quarterly Journal of Economics, February 1995). Explaining the historical (1926–1990) equity premium in the United States using a traditional measure of risk preferences requires an implausible level of risk aversion. The primary finding of this research is that the historical U.S. equity premium can be explained if investors evaluated their portfolios frequently and were loss averse (i.e., they placed greater weight on dissatisfaction from losses versus satisfaction from comparable gains).
One of the financial planning implications from this paper is that investors should evaluate their portfolios annually in order to maximize happiness.
Myopic behavior has been shown to influence the allocation decisions of individuals. Research co-authored by Thaler found that students who were shown monthly returns allocated 59 percent of their hypothetical allocation to a bond fund and the remainder to a stock fund. In comparison, when students were shown annual returns, they allocated only 30 percent to the bond fund and the remainder to a stock fund. This finding is not just limited to students, as workers invest more of their retirement savings in equities if they are shown long-term rates of return.
These findings emphasize the significance of understanding how frequently a client observes investment returns when assessing their risk preferences. These studies also highlight the importance of coaching clients to ignore short-run returns and reporting portfolio returns less frequently (perhaps annually instead of quarterly) to reduce shortsighted behavior.
“Mental Accounting and Consumer Choice” by Richard Thaler (Marketing Science, Summer 1985). Traditionally, it was assumed that the accounts where monies were held should be irrelevant to spending decisions. Mental accounting is the idea that people treat money differently based on its origin. For example, a client may be inclined to spend money from an inheritance differently from earned income, or they may want to pay down low interest debt instead of increasing their retirement savings. In some instances (such as the ones mentioned above) financial planners should protect clients against the fallacies of mental accounting, but this behavioral bias can also be used to help clients focus on their long-term goals.
A bucketing strategy is a mental accounting technique that can be used to help clients link assets with a corresponding goal. When a planner and client are discussing the investment policy statement, the financial planner frames liquid assets, bonds, and stocks as separate buckets of money. For example, liquid assets such as cash, are framed as being in a short-term bucket that is used to fund spending needs over the next five years. Assets like bonds are deemed to be in an intermediate-term bucket that is used to fund goals approximately six to 15 years away (for example, for education). Finally, riskier assets like stocks are framed as being in a long-term bucket that funds retirement goals. The bucketing strategy should help clients focus on longer-term probabilities of payoffs for assets such as bonds and stocks, which has been shown to reduce myopic behavior.
“Gambling with the House Money and Trying to Break Even: The Effects of Prior Outcomes on Risky Choice” by Richard Thaler and Eric Johnson (Management Science, June 1990). Traditional economic theory assumes that the initial value of wealth is irrelevant to financial decisions. However, prospect theory posits that people do take the initial starting value of wealth into consideration when making decisions under uncertainty. The findings from this study provide evidence that both the initial starting value of wealth, as well as prior outcomes, can influence risk-taking.
When individuals experience gains from their initial starting value of wealth, they proceed to take more risk because they are playing with “house money,” a mental accounting phenomenon.
It is important for financial planners to be aware that increased risk-taking may be observed when investors experience stock market gains from their initial portfolio starting value. When people experience losses from their initial starting value of wealth, outcomes that offer them a chance to get back to “break even” become especially attractive. However, if a client experiences losses from their initial starting value without a clear opportunity to get back to even, the research is mixed as to what the investor’s behavioral response might be. Investors tend to hold losing stocks too long (known as the disposition effect). But as losses pile up, investors may also become more loss averse, making it more likely that they would sell out of equities.
“Save More Tomorrow™: Using Behavioral Economics to Increase Employee Saving” by Richard Thaler and Shlomo Benartzi (Journal of Political Economy, February 2004). Another observation by Thaler was that people loathe to make financial decisions. Investors tend to stick with the default option in their defined contribution accounts, and if they do choose an investment allocation, they tend to naïvely diversify by dividing their investments evenly across all available options. Workers also tend to stick with the savings rate percentage that is initially set by their company when they begin employment.
The Save More Tomorrow Plan (also referred to as the SMarT program) was developed as a way to use behavioral economics to increase employee saving rates. Instead of having employees increase their savings rates today, which would result in a loss of income, the SMarT program advocates having people agree to an increase in their savings rate once they receive a raise. This way, the loss averse individual does not experience a lifestyle decline today and does not incur a noticeable decline in income once they receive an increase in pay. Instead, when the client receives a raise, their savings rate climbs and they receive less of a raise, but in absolute terms they are still receiving an increase in income with the added benefit that they are saving more for retirement. The SMarT program has proven to be very effective in practice and has increased savings rates dramatically in defined contribution plans.
The question then becomes whether financial planners can implement the idea of the SMarT program outside of a qualified plan (for example, an IRA). The obvious risk is if a planner gets a client to commit today to saving more in his or her retirement account in the future that the client will not follow through with the commitment. However, if a planner is periodically monitoring the client’s financial plan, he or she can quickly intervene when a salary increase occurs to make sure that the client follows through with their commitment.
The SMarT program may not resolve the issue of helping an older client who is approaching retirement to save more, but it could help younger clients to save more in the future without causing a noticeable change to their lifestyle.
Conclusions
Some academic research includes economic assumptions that are unrealistic and thus the findings may not be directly relatable to financial planning practitioners. However, over the past two decades, the field of behavioral economics has chipped away at traditional academic thought that people should be modeled as rational robots and instead has focused on the ability to predict, at least to some extent, deviation from rationality.
Arguably no research in this area is more applicable to financial planners than the work of Richard Thaler. His research has provided practical insights that can and should be used by financial planners to better understand client behavior.