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Lessons Learned at Harvard: Easy Solutions to Baffling Problemsby Paul A. Merriman Publisher and Editor
Late in April I had the privilege of taking part in the Sixth Conference on the Psychology of Investing at Harvard University. It left me feeling more convinced than ever of how important it is for investors to follow something other than their emotions.
This conference focused on the emotional hurdles of real-life investing. That’s my specialty, and I want to share with FundAdvice.com readers a lot of the things I learned. Consider this article a “down payment” on that promise, and watch for more insights in future articles later this year.
ULTIMATELY, MOST AMERICANS ARE NEARLY BROKE WHEN THEY RETIRE.The conference participants included authors, money managers, academics and one of the nation’s most respected futurists. Their experience and research indicate that investors are often their own worst enemies.
I’d like to start by summarizing some of the ways that happens, based on research described by David I. Laibson, a Harvard economics professor.
Most people don’t save enough money. A survey in 1997 by Public Agenda, a nonpartisan opinion research organization in New York, found that 76 percent of the respondents believed they should be saving more money for retirement. Among those who said they believed they should be “seriously saving” for retirement, only 6 percent said they were ahead of where they should be in their plans, while 55 percent said they were behind where they ought to be. People’s financial habits are counter-productive. Here’s one example: One-third of participants in 401(k) programs are currently borrowing against their retirement savings. This debt is often described as benign because the required interest payments are made “to yourself.” But in fact, these loans carry very high risks. If the borrower changes jobs, is laid off or for any other reason stops participating in the 401(k) plan, the full balance of the loan is due immediately. Any part of the loan that is not paid off is treated by the IRS as a withdrawal subject to taxes and (except for employees who are 59½ or older) a 10 percent penalty for early withdrawal. Worse, I don’t think the majority of 401(k) borrowers understand this risk. People’s financial habits are counter-productive, Part II. Average credit card debt per household is $8,000. The average interest rate on this debt is 16 percent. Typical credit card agreements require 2 percent of the balance to be paid each month (or $20, whichever is less). Even if a household stopped making any new charges, paying off an $8,000 balance by making the minimum payments while incurring interest of 16 percent, would take more than 31 years. And in the process, that household would pay total interest of $14,104.
Ultimately, most people are nearly broke when they retire. The median U.S. household (median means half are above this figure, half are below) retires with liquid wealth of $15,000 and a net worth of $130,000. Most of that net worth is in home equity and vehicles.
All this is very sobering to anyone dedicated to helping other people help themselves.
Why does this happen on such a large scale among a population that’s one of the best-educated and most privileged in the world?
Irrational behavior
Dr. Laibson believes Americans are irrational, have only weak self-control and we are unrealistically and bountifully optimistic. I think there’s a fourth factor at work: Too many Americans are passive and just don’t want to be bothered.
Laibson says mainstream economists assume (incorrectly) that American consumers are rational beings. You can hear this assumption often in newscasts that attempt to explain economic behavior of all sorts: “In response to the deteriorating demand for labor, Americans tightened their belts and deferred purchases of durable goods.” This sounds wonderful in theory. But do you know anybody who decides whether to buy a new washing machine on the basis of economic statistics?
On the other hand, behavioral economists – and Laibson counts himself among them – believe that consumers have a lot to learn. Laibson cited a study by the U.S. Department of Education that found among a group of men and women 21 to 25 years old that:
Only 40 percent could calculate the change due to a customer after a purchase of two items. Only 20 percent could accurately read and interpret a bus schedule.
How many of these young people do you suppose can read and understand the Wall Street Journal?
Obviously, most young people don’t have a lot of incentive to learn to make change and figure out bus schedules. But even when the stakes are high, most people don’t seem to have a lot of motivation. Less than a third of Americans who are over 26 years old and have not yet retired have tried to figure out how much savings they will need in order to live comfortably in retirement.
401(k) follies
But what about people who invest regularly? Surely they must be more sophisticated about finances.
Laibson and other researchers wanted to test that notion, and they figured that an excellent way to do so is to monitor how people manage their 401(k) investments. Most such accounts give employees a range of choices so they can allocate their money between stocks, bonds and cash or the equivalent.
Investment advisors and financial columnists pay a lot of attention to how 401(k) money should be invested. But the research suggests a lot of employees don’t care very much. Laibson described a study in which employees were told how, on average, their fellow 401(k) participants had allocated their assets. Most of the workers in the study said they thought the average allocation of other workers was better than their own.
Other research indicates many employees believe all plan options are of equal value. If a plan has three stock funds and one bond fund, participants’ average allocations are typically 75 percent in equities. If a plan has only one stock fund and three bond funds, average allocations are typically only 25 percent in equities. This is not what I would call the behavior of savvy investors.
A survey of retirement plan participants by John Hancock found a startling level of ignorance. Nearly half (47 percent) believed that money-market funds are made up partly of stocks. About the same number (49 percent) thought money market funds are made up partly of bonds. Only 9 percent knew the truth: Money-market funds contain only short-term fixed-income securities.
That survey also found that only one of every four participants understood the inverse relationship between interest rates and bond prices – that when interest rates rise, bonds lose value. That is very important information for any bond investor to know, especially these days. (I am certain that after a few months of rising interest rates and falling bond prices, I’ll start hearing from investors who have no clue about what has happened to the bond funds they thought were so safe.)
Laibson cited research about taxable accounts as well. He said a typical investor with taxable assets loses three percentage points of return each year in tax payments and unnecessary transaction costs: 2 percent to taxes and 1 percent more than necessary in mutual fund management fees. Load fund investors, of course, pay much more for the privilege of owning funds.
This casual approach is enormously expensive. Laibson cited the cost of losing 3 percentage points of investment returns over 40 years. “If I invest $100,000 for 40 years, a 10 percent return per year will generate a balance of $4.5 million. If I invest $100,000 for 40 years, a 7 percent return per year will generate a balance of $1.5 million.”
“Mainstream” economists believe that consumers make careful plans and carry them out. This assumption is very convenient in an ivory tower, as it gives academics an easy tool to explain behavior. If consumers do a certain thing, that must mean they were planning to do it.
But Laibson thinks that’s a myth. Many consumers make plans. But they aren’t at all diligent about carrying them out. Instead, they give in to temptation. Laibson says Americans are so eager for instant gratification that over and over they short-change themselves. He cited a simple question that researchers often ask subjects during meetings, classes and workshops: Which would you prefer, a 15-minute break today or a 30-minute break tomorrow? Time after time, 15 minutes today is perceived as more valuable than 30 minutes tomorrow.
Here’s an interesting variation: Which would you prefer, a 15-minute break 100 days from now or a 30-minute break 101 days from now? In this case, people seem very willing to wait another day in order to get a longer break – you may have had the same immediate reaction yourself.
But in fact, the choice in these two questions is actually exactly the same: a 15-minute break one day or a 30-minute break one day later.
Overheard in the subway
I once overheard a form of this in what may be an unusually philosophical conversation between two teenage girls on a subway train in New York City. Girl A: “Would you rather be beautiful now, knowing you would gradually get ugly in later life, or would you rather be ugly now and know that you’d be beautiful later?” Girl B: “That’s easy. I’d be beautiful now.”
We make long-term plans, then undermine them with our short-term actions. For the long term, we intend to be patient and delay our gratification. We’ll quit smoking, start exercising, lose weight. Financial planners advise their clients to “save early and save often.” Baby boomers say they want to save 15 percent of their incomes.
But real life seems to get in the way. The actual median savings rate is 5 percent. The average smoker has tried to quit four times. The typical employee procrastinates about two years before enrolling in a 401(k) plan after it is offered or after the employee becomes eligible.
In a survey of 100 workers in a large company, 68 said they were saving too little money. Of those 68, 24 said they planned to increase their savings rate within three months. After three months, only three of the 68 actually did so.
MOST 401(K) PARTICIPANTS CHOSE WHATEVER INVESTMENT OPTIONS WERE THE EASIESTTwo professors found that the average cost of a one-month membership to a health club was $75. On average, members visited their clubs four times a month, meaning they were willing to pay $19 per visit. The same clubs on average charged $10 per session for pay-per-visit memberships.
Americans hold about 10 million “Christmas Club” accounts at banks, thrift institutions and credit unions. These accounts pay no interest, but they are popular because they build savings through automatic deposits from checking accounts – and even from interest-paying savings accounts.
Similarly, the majority of U.S. taxpayers get IRS refunds every year, through excess withholding from their paychecks. Workers like this “forced” savings because the money is automatically taken from their pay before it can be spent.
Garrison Keillor: “In Lake Wobegone, we believe in salting money away, not only as an investment but also to remove it as a temptation.”
Everybody’s above average
In that respect, consumers’ beliefs appear to reflect reality. But many behavioral economists, including Laibson, believe that consumers wear rose-colored glasses. We tend to be so optimistic that we fool ourselves.
When asked to compare themselves with their peers, research subjects almost always report a self-enhancing bias that reminds one of Lake Wobegone, “where all the children are above average.”
Relative to their peers, research subjects reported that in comparison to the general population, they were more intelligent, more likely to succeed at work, more likely to enjoy their job and more likely to have good marriages.
These researchers must love their jobs, since they get to meet such outstanding people!
The list goes on, with subjects reporting that compared to others they are more likely to own homes that appreciate, more likely to live beyond age 80 and more likely to make money in the stock market. In one study, 70 percent of the subjects reported that they were safer drivers than most of the population.
What Laibson calls “unbounded optimism” leads to unrealistic expectations. In 1998, the average investor expected the stock market to continue to grow 20 percent a year for the next decade. A common attitude among young people is: “My financial situation will improve in the future, so I don’t need to start saving now. I’ll do it later.”
Another case study done by Laibson and three other researchers makes me wonder how many workers even care about their 401(k) savings. The study tracked the behavior of employees in two companies that switched their 401(k) signup procedures.
In the first company, before the change, new employees could choose to sign up for the program by checking a box on a form. If they didn’t check the box, they did not participate. Only about 30 percent of the employees in the company signed up.
Then this company made a change. Now, every employee that was not in the plan was given a choice to stay out of it. But unless they actively chose against participation, they were automatically signed up. After the change, about 90 percent of the employees were in the plan.
The great majority of employees in this company took the easiest course (not checking a box), whether that resulted in not participating (before the change) or in participating (after the change). Whatever was easiest, that’s what most of them did.
INVESTORS ARE TOO OPTIMISTIC. THEY HAVE TOO LITTLE SELF DISCIPLINE. AND THEY MAKE NON-RATIONAL DECISIONS
After the change, the workers who were new to the plan could specify what percentage of their pay was saved, and how it was allocated among various investment choices. But if they didn’t check other boxes on the form, they were given the “default” arrangement of 2 percent contribution, all of it going into a money-market fund. About two-thirds of the new participants chose the default allocation, a money-market fund – a pretty poor choice for most people in a 401(k) plan.
The second company in this study, before it made a change, also allowed new employees to sign up for the plan – and those who didn’t sign up were excluded. In other words, the default choice was not to participate. Only about 30 percent of the employees had checked the box and were in the plan.
Then the company changed its forms, and all new employees had to check one box or another, to participate or not. There was no more default option. After this change, participation grew to 50 percent.
After I returned from the Harvard conference, another study of 401(k) behavior was reported that I found equally instructive.
Nebraska as a case study
The state of Nebraska did a study of its 38-year-old 401(k) system in action and pronounced it a failure, largely because of the choices made by employees. Nebraska was an innovative employer. In 1964, it started letting workers choose between staying with the state’s traditional defined-benefit pension plan or joining a new self-directed 401(k).
The state required all workers to contribute part of their pay either to the pension plan, which guaranteed retirement benefits based on salaries and length of service, or to the 401(k), which guaranteed retirees that they could direct their own courses and take their accumulated investments at retirement – while of course they received no pension.
Nebraska didn’t merely leave 401(k) participants to their own devices, as most corporate 401(k) plans do today. The state let participants take time off from work to attend daylong educational investment seminars, something that few employers do today.
Two years ago, the state studied its 401(k) system, one of the oldest in the country, and found that over the past 30 years the typical participant had an average annual return of 6 percent to 7 percent. That compared with about 11 percent annual returns that the state’s traditional pension fund managers achieved in the same time frame.
The bulk of Nebraska’s 401(k) participants did not allocate their investments successfully. Nebraska offered 11 fund choices. But 90 percent of the contributions wound up in only three funds – and half of all 401(k) money was in the default option, a low-paying guaranteed investment contract fund.
State officials began to fear they were wasting taxpayer dollars by giving matching contributions.
The result: Existing employees can stay in the 401(k) plan. But after next January, new Nebraska employees will no longer have the 401(k) plan as a choice.
Whether or not other employers follow suit, Nebraska’s experience is very sobering, especially since it spans a long time period and especially since the state went far out of its way to help employees learn to do the right things. The lesson seems to be that the majority of employees didn’t care enough to be bothered. Unfortunately, Nebraska’s experience reinforces some of the findings reported at the Harvard conference by Laibson.
Investors need an automatic pilot
At the conference, I was pleased to be able to present my answer to many of the problems that were outlined by Laibson and others. While I don’t have the academic credentials of those professors, I have a lot of hands-on experience, and I know a lot about investors and their behavior.
AUTOMATIC SAVING, AUTOMATIC TIMING AND AUTOMATIC DIVERSIFICATION ARE THE KEYS TO REAL-LIFE SUCCESS FOR MOST INVESTORS
Most of the investors I deal with are not as passive or apparently misguided as those studied by the Harvard professors. But many investors are much too optimistic. Many investors have an awful time with self-discipline. And many investors make non-rational decisions about their financial affairs. How else would you explain all the money in non-interest-bearing Christmas Club savings accounts?
Laibson offered four pieces of advice to investors: First, don’t try to pick star managers. “You won’t be the one to discover the next Warren Buffett,” he said. Instead, invest in index funds, including U.S. and international stock funds, U.S. bond funds and inflation-linked bonds. Second, don’t trade; instead, buy and hold. Third, shift your portfolio more toward bonds as you grow older. Four, avoid commission-based financial advice, which he described as “snake-oil.”
I agree with those points. But as I said in my address to the conference, they are insufficient. We already know that people who have great plans, strong intentions and clear instructions can still sabotage themselves with irrational, impulsive behavior.
Readers of this newsletter won’t be surprised at my recommendations, which appeared to impress many people at the conference. My prescriptions could be summed up in a single sentence: Make good saving and investing habits automatic.
Mechanical savings
If people lack the self discipline to set aside money every time they get paid, they can make that automatic in a variety of ways through payroll deductions or regular automatic withdrawals from their checking accounts. The money can go into a bank account, a 401(k) plan, a credit union or a mutual fund through an automatic investment plan. This is the only foolproof way to make sure you “pay yourself first.”
Mechanical diversification
No-load index funds give investors enormous diversification in cost-efficient packages. There’s no need to choose managers or pick stocks. The market does that, automatically, through index funds. These should make up the bulk of a properly diversified buy-and-hold portfolio.
Mechanical timing
I share Laibson’s view that buying and holding is far more likely to succeed than active trading. But market timing, if it is done properly, can reduce risk and improve returns over the long run. Not every investor wants or needs timing. But for those who use this approach, the only timing I practice and the only timing I advocate is mechanical timing. Mechanical systems make it unnecessary to analyze economic and market data or agonize over when to buy and when to sell. These systems are based on facts, not forecasts, and they give unambiguous buy and sell signals.
Automatic saving, automatic timing and automatic diversification can’t work miracles. They can’t make up for decades of lost time when individuals chose to spend instead of save. They can’t change the effects of bear markets.
But if they are applied with discipline and patience, they can make successful investing possible for most individuals. And they don’t require a Harvard education.
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