Behavioral Finance for Financial Planners

transcript

This is your

brain on finances:

Associate Professor Russell James, J.D., Ph.D., CFP®Director of Online Graduate Studies in Charitable Financial Planning

Texas Tech University

Advising imperfect humans

• A current example of a brain science “work in progress”

• A neuro-economic model of decision making

• Strategies for influencing financial decision making

Brain science methods• Behavioral

– Cognitive abilities, Mathematic abilities, Choices

• Neurological– Lesion/stroke studies– Other signal receiving methods

• Functional Magnetic Resonance Imaging (fMRI)

• Positron Emission Tomography (PET)*• Single photon emission computed

tomography (SPECT)*• Electroencephalography (EEG)**• Magnetoencephalography (MEG)**

*Requires radioactive injections **Great at WHEN activation, weak at WHERE activation

Graduate personal financial planning research & theory class

In progress study…

A sharing game: Player 1 receives $20. Any amount he gives to Player 2 is tripled. Player 2 may return any amount to player 1. The game ends. Players are anonymous and unseen.

There is no economic reason for Player 2 to share any money. Measures generosity-attachment-reciprocity.

• A prior study found that touch (therapeutic massage) combined with receiving a larger share from Player 1 caused Player 2 to be more generous than with either element alone (Morhenn, et al 2008).

• Significantly, the generosity was driven by changes in oxytocin, a family/in-group bonding hormone.

In our fMRI study for touch, a lab assistant takes the subject’s pulse during some blocks of the trials

Attempting a practical analogy to a business practice such as a handshake and a small gift.

We care about activation in the amygdala, which has been shown to respond to faces of in-group members more than out-group members following a team building exercise

Adding touch to a high sharing scenario may increase activation

Adding touch to an “unfair” low-sharing scenario may have a negative effect on activation

Moving from low sharing to high sharing in a touch scenario may increase activation

A framework for thinking about the neurological processes of human decision-making

The “dual-self” model as an alternative to simple “utility-maximizing” rational decision-making

Long-run (patient) self• This side tries to

maximize utility across time

Short-run (impulsive) selves• Sequential selves that exist

only for a brief time• Each cares only about

immediate experience

Drew Fudenburg (Harvard U.) and David K. Levine (Washington U.), 2006, A dual-self model of impulse control. American Economic Review, 96(5), 1449-1476.

“Our theory proposes that many sorts of decision problems should be viewed as a game between a sequence of short-run impulsive selves and a long-run patient self.”

R.H. Thaler (Santa Clara) & H. M. Shefrin (Cornell), 1981, An economic theory of self-control, Journal of Political Economy, 89(2), 392-406.

“The planner is concerned with lifetime

utility…”

R.H. Thaler (Santa Clara) & H. M. Shefrin (Cornell), 1981, An economic theory of self-control, Journal of Political Economy, 89(2), 392-406.

“the doer exists only for one period and is completely selfish or myopic.”

Examples of dual-self models in behavioral economics

Short-term/impulsive

Passions

Affective/Visceral

Hot state

Long-term/patient

Planner

Impartial spectator

Deliberative

Cold state

Adam Smith

Loewenstein

Fudenberg & Levine

Bernheim & Rangel; Loewenstein

Shefrin & Thaler

Or we could look at neurology

“A crucial fact is that the human brain is basically a mammalian brain with a larger cortex. This means human behavior will generally be a compromise between… animal emotions and instincts, and… human deliberation and foresight.”

C. Camerer (Cal Tech), G. Loewenstein (Carnegie-Mellon), D. Prelic (MIT), 2004, Neuroeconomics:

Why economics needs brains. Scandinavian Journal of Economics, 106(3), 555-579.

Can we see two systems in the brain?

Areas of the prefrontal cortex are associated with rational, higher cognitive thought.

The more central limbic system is the immediate reward system (“dopaminergic”).

Watching decision-making happen

By making decisions in an fMRI machine, we can see which areas of the brain are activated.

BOLD signal indicates blood usage in the area.

Limbic system reactions

Choices between more $ later, less $ sooner.Earliest option: TodayEarliest option: 2 Weeks Earliest option: 1 month

S. McClure (Princeton), D. Laibson (Harvard), G. Loewenstein (Carnegie Mellon), J. Cohen (Princeton), 2004, Separate neural systems value immediate and delayed monetary rewards. Science, 306, 503-507.

Higher cognitive system reactions

Choices between more $ later, less $ sooner.Earliest option: TodayEarliest option: 2 Weeks Earliest option: 1 month

S. McClure (Princeton), D. Laibson (Harvard), G. Loewenstein (Carnegie Mellon), J. Cohen (Princeton), 2004, Separate neural systems value immediate and delayed monetary rewards. Science, 306, 503-507.

Hyperbolic discounting

• Would you rather receive $100 right now or $101 in a week? Most people choose $100 right now.

• But when the choice is between $100 a year from now and $101 in a year and a week from now, most people choose $101 in a year and a week.

• This is time inconsistent, as both choices involve delaying by one week for $1.

Note also that choosing $100 right now implies an interest rate charge of 1% per week or APR of 52%

Dual-self exampleRead & van Leeuwen (1998). 200 participants. People who were not hungry, chose the unhealthy snack for delivery in one week

26% of the timeThey chose the unhealthy snack for immediate consumption

70% of the time

← Next Week

Right Now → 26%

Let’s use a simple analogy“The image that I came up with … was that I was a rider on the back of an elephant. I’m holding the reins in my hands, and by pulling one way or the other I can tell the elephant to turn, to stop, or to go. I can direct things, but only when the elephant doesn’t have desires of his own. When the elephant really wants to do something, I’m no match for him.”

Dr. Jonathan Haidt, (University of Virginia), The Happiness Hypothesis, 2006, p. 4, Basic Books: New York.

Elephant in charge

Short-termImpulsive DoerPassionsAffective/VisceralHot state

Long-termPatient PlannerImpartial spectatorDeliberative Cold state

If given total control, the “elephant” side makes choices detrimental to future success and happiness.

How can we change?

1. Alter our time preference (develop future-orientation or patience)

2. Pre-commitment strategies (change our elephant’s future environment)

How do we work to develop more future-orientation (patience)?

Victim of my insatiable need for instant gratification.

Economic Theory

• Nobel prize winning economist Gary Becker and Casey Mulligan present a model of time preference for imperfect humans.

• People may be too focused on instant gratification, but they can spend effort to develop patience (future-orientation).

G. Becker (Chicago) & C. Mulligan (Chicago), 1997, The endogenous determination of time preference. Quarterly Journal of Economics, 112(3), 729-758

Economic theory: People maximize…

The enjoyment of current consumption

The enjoyment of future consumption

A time discount factor (because future enjoyment is not the same as current enjoyment)

Becker & Mulligan say we can change it by spending effort (S) to become more future-focused.

In standard economics, our time discount preference (β) is pre-set.

G. Becker (Chicago) & C. Mulligan (Chicago), 1997, The endogenous determination of time preference. Quarterly Journal of Economics, 112(3), 729-758 , p. 734

A consumer can “make future pleasures less remote by spending resources (S) on imagining them”

G. Becker (Chicago), 1996, Accounting for Tastes. Cambridge, Massachusetts: Harvard University Press, p. 11

People can maximize utility “partly by spending time and other resources to produce

‘imagination capital’ that helps them better appreciate future utilities.”

A Nobel prize winning economist using an economic model incorporating

Imagination

“How can a person improve his capacity to appreciate the future? What exactly is S? First, S is partially determined by time and effort spent appreciating future pleasures.”

“While forming a mental picture of one’s future pleasures may not be incredibly difficult, the process of anticipation is not merely one of image formation but also one of scenario simulation.”

“Even image formation may not be cheap because images of future pleasures have to be repeatedly refreshed in one’s mind in order to compete with current pleasures.”

http://www.youtube.com/watch?v=wPFA8n7goio 1:13-4:30

Only emotional goals work

• The rider may be compelled by logic or emotion

• The elephant is purely emotional (visceral)

• To engage the elephant, the imagery of future goals must evoke emotion

Time horizon and wealth building

In 1998 about 5,000 people over 50 were asked:“In planning your saving and spending, which of the following time periods is most important to you,

the next few months, the next year, the next few years, the next 5-10 years, or longer than 10 years?”

Comparing people with the same starting wealth, did those with longer time horizons accumulate more

wealth in the following 8 years?

Wealth growth and time horizon

Comparing with the wealth growth of other people with the same starting wealth:

Answer in 1998: Financial Planning Time Horizon

1998-2006 change in wealth v. Others with identical starting wealth

next few months No significant differencethe next year No significant differencethe next few years No significant differencethe next 5-10 years + $157,427 more than otherslonger than 10 years + $240,699 more than others

Other research finds:Planning ahead→wealth“Why do similar households end up with very different levels of wealth?”

“We … measure each household’s ‘propensity to plan.’ We show that those with a higher such propensity spend more time developing financial plans, and that this shift in planning is associated with increased wealth.”

Ameriks, J., Caplin, A. (NYU), Leahy, J. (NYU). 2003. Wealth accumulation and the propensity to plan. Quarterly Journal of Economics, 118(3), 1007-1047.

Focusing on long-term goals using imagery and emotion can change your future-orientation.

1. Alter our time preference (develop future-orientation or patience)

2. Pre-commitment strategies (change our elephant’s future environment)

Pre-commitment gives the rider control over the elephant’s future environment.

Many Temptations

Few Temptations

1.Change the

rewards and

penalties

2.Change the number of

decision points

Pre-commitment Strategies

The goal is to change the environment as perceived by the elephant.

The elephant is 1. Emotional2. Focused on now 3. Fears loss

1. Change the rewards and penalties

Elephant characteristic

1.Emotional

2.Focused on now

3.Hates loss

Approach

Change peer group & social rewards to alter emotional payoffs of future choices

Change immediate rewards of future choices

Reframe the felt losses of future choices

Are professors’ retirement savings affected by their peers’ savings?

Duflo, E. (MIT) & Saez, E. (Harvard), 2002, Participation and investment decisions in a retirement plan: the influence of colleagues’ choices. Journal of Public Economics, 85, 121-148.

“When participation [in a retirement savings program] increases by 1 percent in the department, one’s participation increases by 0.2 percent.”

Are professors’ choice of mutual fund company affected by their peers’ choice?

Duflo, E. (MIT) & Saez, E. (Harvard), 2002, Participation and investment decisions in a retirement plan: the influence of colleagues’ choices. Journal of Public Economics, 85, 121-148.

“When the average share of the contribution invested in one vendor increases by 1 percent, one’s share in this vendor increases by 0.5 percent on average.”

Financial peer groups – Microfinance

http://www.youtube.com/watch?v=nMg_Lc6akos (0:00-1:45)

2. Focused on now Change immediate rewards of future choices

Reducing the immediate payoff

Adding Felt Losses

Increasing the immediate payoff

Removing Felt Losses

Negative Choices Positive Choices

3. Hates loss Reframe the felt losses of future choices

Why losses hurt more

Is there a conflict between the core “elephant” side of the brain and the rational pre-frontal cortex “rider”. Why?

http://www.youtube.com/watch?v=GGQLO_iXKlU 3:06-end

Illiquidity may encourage wealth accumulation by reducing the temptation to consume.

D. Laibson (Harvard), 1997, Golden eggs and hyperbolic discounting. Quarterly Journal of Economics, 112, p.444.

“All Illiquid assets provide a form of pre-commitment”

Minor Penalty

ModestPenalty

Current income + High transaction costs• Housing, farm,

family business, Consumer durable

Unavailable• Pension, Christmas Club Account, Excess tax withholdingPenalty for withdraw• CDs, IRAs, 401(k)s

Adding felt losses – paying with cash

“In studies involving genuine transactions of potentially high value we show that willingness-to-pay can be increased when customers are instructed to use a credit card rather than cash. The effect may be large (up to 100%).”

D. Prelec (MIT) & D. Simester (MIT), 2001, Always leave home without it: A further investigation of the credit-card effect on willingness to pay. Marketing Letters ,12, 5-12

Cash Check Credit25%27%29%31%33%35%37%39%41%43%45%

% spent on non-essential treats and lux-uries at grocery store

D. Soman (U. of Toronto), 2003, The effect of payment transparency on consumption: Quasi-experiments from the field. Marketing Letters, 14, 173-183.

Removing felt losses

• Pre-paying for the gym• The automatic millionaire • Save more tomorrow• Keep the change• Tax refund splitting

Removing felt losses:Save more tomorrow

• People commit in advance to allocating a portion of their future salary increases toward retirement savings.

• “the average saving rates for [Save More Tomorrow] program participants increased from 3.5 percent to 13.6 percent over the course of 40 months.”

R. Thaler (University of Chicago), S. Benartzi (UCLA), 2004, Save more tomorrow: Using behavioral economics to increase employee saving. Journal of Political Economy, 112, S164-S186

Removing felt losses:Bank of America’s Keep the Change

“each time you buy something with your Bank of America Check Card, we’ll round up your purchase to the nearest dollar amount and transfer the difference from your checking account to your savings account.”http://www.bankofamerica.com/promos/jump/ktc/ downloaded 7 Nov. 2009

Removing felt losses: Tax refund splitting

• Tax refund splitting is a pre-commitment to put a portion of the tax refund into a savings account

• In a pilot program “those that did participate saved 236% more than they said they would before hearing about the program”

A. Chiou, S. Roe, E. Wozniak, advisor E. Luttmer (Harvard), 2005, An evaluation of tax-refund splitting as an asset-building tool for low-to-middle income individuals. http://www.d2dfund.org/system/files/publications/PAE+R2A2+FINAL.pdf

The problem of felt losses in investing• Investors prefer to realize gains (sell

winners) but not losses (hold losers). This lowers returns as compared to “buy and hold” strategies.

• Among active traders, “Men underperformed their buy-and-hold portfolios by 2.652 percentage points annually; women underperformed their buy-and-hold portfolios by 1.716 percentage points annually.”

B. Barber (UC-Davis) and T. Odean (UC-Davis), Nov/Dec. 1999, The courage of misguided convictions. Financial Analysts Journal, 41-55

NEXT 2.Change the number of

decision points

Pre-commitment Strategies

Each decision point is an opportunity to change direction

Increase decision points

required for

negative options

Decrease decision points

required for

positive options

Increasing decision points required for negative options

Decreasing decision points Required for positive options

Mental accounts(partitions)

In standard economics a dollar is a dollar is a dollar. Money is “fungible”

In behavioral economics, people put money into different mental categories and react differently to fluctuations in different categories

Three broad mental accounts (partitions)

Asset account

• Savings account, stocks & bonds

• Designated for saving

Current income account

• Checking account, cash• Routinely Spent

Future income account

• Retirement savings • Rarely spent

Asset account

Current income account

Future income account

“People typically show different propensities to consume from their current income (where marginal propensity to consume [MPC] is high), current assets (where it is intermediate), and future income (where it is low).”

M. Bertrand (U. Chicago), S. Mullainathan (MIT), & E. Shafir (Princeton), 2004, A Behavioral-Economics View of Poverty. American Economic Review, 94, 419-423, 420

Financial partitioning device

A credit request freeze allows consumers to freeze their credit files. No credit applications without going through the thaw request process.

Example:Putting your credit card in a block of ice

Gold Credit Card0000 2222 1001 0051

Can you implement your own mandatory cooling off periods?

Other ideas?

Increasing decision points required for negative options

Decreasing decision points Required for positive options

800,000 eligible employees at 657 companies401(k) plans ranged from 2 to 60 investment options

As choices increased what happened to the likelihood of investing?

a) Decreased b) Increased c) Stayed the same

S. Botti (Cornell) & S. S. Iyengar (Columbia), 2006, The dark side of choice: When choice impairs social welfare. Journal of Public Policy and Marketing, 25(1), 24-38.

Our decision-making can be thought of as the outcome of a game between the “elephant” and the “rider”. The elephant is (1) emotional, (2) focused on now, (3) fears loss

The elephant is stronger, but therider can alter the elephant’s future environment by (1) Emotional future

imaging (2) Changing the elephant’s

future rewards and penalties through pre-commitment

(3) Changing the number of decision points

Behavioral Finance for Financial Planners

Economy & Finance