February 14, 2002
Investor Behavior Plays Role in Debate Over Wider Choice in 40l(k)'s
By HAL R. VARIAN
fter the Enron (news/quote) collapse, Congress is debating whether to limit the amount of their own company's stock that employees can put into their 401(k) retirement plans.
Those in favor of such caps, like Senators Barbara Boxer and Jon S. Corzine, see them as a way to encourage diversification and reduce risk. Those opposed, like Labor Secretary Elaine L. Chao, say such caps violate freedom of choice.
Economists generally believe that more choice is better, but even economists acknowledge that there are plenty of exceptions in real life. Offering a cigarette to someone trying to quit smoking, a drink to a recovering alcoholic or a candy bar to a dieter isn't doing that person a favor.
To most economists, the problems illustrated by these examples are anomalies. But to one group, behavioral economists, the examples are central.
Clearly, more choice is not better when people have problems with self-control. Behavioral economists have also identified several other reasons that more choice can make consumers worse off, reasons that affect everything from marketing strategy to pension policy.
Start with marketing.
Two researchers, Sheena S. Iyengar and Mark R. Lepper, set up sampling booths for jam in a supermarket. One offered 24 flavors, and one offered only 6. More people stopped at the larger display, but substantially more people actually bought jam at the smaller display.
More choice seemed to be attractive to shoppers, but the profusion of choices in the larger display appeared to make it more difficult for the shoppers actually to reach a decision to buy.
Shlomo Benartzi and Richard Thaler, two behavioral economists, wondered whether the same problem with "excessive choice" showed up in investor decisions. They found that people who designed their own retirement portfolios tended to be just as happy with the average portfolio chosen by their co-workers as they were with their own choice. Having the flexibility to construct their own retirement portfolios didn't seem to make investors better off.
In some investment situations, more choice can be downright dangerous. Two finance professors, Brad Barber and Terrance Odean, studied the performance of 66,465 households with discount brokerage accounts. Households that traded infrequently received an 18 percent return on their investments, while the return for the households that traded most actively was 11.3 percent.
In the words of Mr. Barber and Mr. Odean: "Trading is hazardous to your wealth."
In later work, these financial economists investigated who it was that traded too much. They found that one important determinant of excessive trading was gender.
Psychologists consistently find that men tend to have excessive confidence in their own abilities, a fact that will come as no surprise to most women.
Several years ago my wife asked me, "Do you know why NASA decided to put women on the team of astronauts?" She replied: "So when they get lost, someone will be willing to stop and ask for directions."
Male overconfidence shows up not only in navigation skills but also in investor behavior: Mr. Barber and Mr. Odean find that on average, men trade 45 percent more than women. They also find that this excessive trading reduces men's net returns by almost a full percentage point.
(Note to my wife: my record as an investor is better than my record of asking for directions.)
Psychologists find that men tend to suffer from "self-serving attribution bias." In plain language: men tend to think their successes are a result of their own skill, rather than dumb luck, and so become overconfident.
It is not hard to see how overconfidence might lead to bubbles: though frequent traders lose on average, sometimes they luck out. If many happen to get lucky at the same time, they will attribute this success to their superior abilities and double their bets. This pushes up the value of stocks even more, leading to more excessive confidence and an unsustainable boom in stock prices.
If we accept this evidence that investors have problems with self-control, poor decision making and overconfidence, what can we say about the regulation of financial markets and pensions?
It has long been recognized that financial markets seem to exhibit excess volatility. Some economists have advocated a tax on transactions as a way to curb excessive trading. Regardless of its merits, such a plan would be almost impossible to put in place, since anyone with a computer and an Internet connection can set up an offshore market.
But tax barriers already exist that discourage excessive trading. Since capital gains taxes are paid only when a stock is sold, that tends to reduce stock turnover. Perhaps that's not such a bad thing for financial market stability. And if we believe the studies cited earlier, at least some investors may be helped by this tax, because it reduces their propensity to trade excessively.
With respect to pension policy, the findings from behavioral economics described above suggest that mandated savings plans, like conventional defined-benefit pension plans and Social Security, are pretty good programs. The tendency in the last several years has been to offer employees more choice of retirement options. But if individuals do not make good choices when left to their own devices, this may not be appropriate.
Some may object to such considerations as overly paternalistic. But those unfortunate investors who find their retirement portfolios worthless may end up relying on public assistance of one form or another. Even extreme libertarians may be willing to face some restrictions on their retirement choices, so long as they won't be required to bail out fellow retirees who make excessively risky choices.
Many employees of Enron, Global Crossing, Lucent (news/quote) and Nortel have seen their pensions evaporate when the price of their company stock dropped. If these investors had held more diversified portfolios, they would be sleeping a lot more soundly today.