The Behavioral Economics of Savings

Some quotes from the insightful (and surprisingly amusing) The Behavioral Economics of Retirement Savings Behavior, by (Nobel Laureate) Richard H. Thaler and Shlomo Benartzi (emphasis added):

Investment in company stock is another tendency that defies all the logic of diversification, and yet investors persist in the belief that investing in company stock is no more risky than investing in any other mutual fund.

Picking the best point on the efficient frontier is easier said than done. Indeed, when asked about how he allocated his retirement investments in his TIAA-CREF account, Nobel laureate Harry Markowitz, the “father” of modern portfolio theory, admitted that “I should have computed the historic covariances of the asset classes and drawn an efficient frontier. Instead, … I split my contributions fifty-fifty between bonds and equities.

Markowitz’s strategy is a simple example of a naïve diversification strategy: when faced with “n” options, simply divide assets evenly across the options. […] For a concrete example, consider the following experiment Read and Loewenstein (1995) conducted one Halloween night. The “subjects” in the experiment were young “trick-or-treaters”. In one condition, the children approached two adjacent houses and were offered a choice between two candy bars (Three Musketeers and Milky Way) at each house. In the other condition, they approached a single house where they were asked to “choose whichever two candy bars you like.” Large piles of both candies were displayed to ensure that the children would not think it was rude to take two of the same. The results showed a strong diversification bias in the simultaneous choice condition: every child selected one of each candy. In contrast, only 48 percent of the children in the sequential choice condition picked different candies. The remaining 52 percent picked two of the same candies, presumably their favorite.

One of the most extreme examples of poor diversification is the case of employees investing in their employer’s stock. Mitchell and Utkus (2004) estimate that five million Americans have over 60 percent of their retirement savings invested in company stock. This concentration is risky on two counts. First, a single security is much riskier than the portfolios offered by mutual funds. Second, as employees of Enron and WorldCom discovered the hard way, it is possible to lose one’s job and the bulk of one’s retirement savings all at once.

It turns out that most of the supermarket employees considered the store butcher to be the investment maven and would turn to him for advice. Depending on the investment philosophy of the butcher at each individual location, employees ended up being heavily invested in stocks or heavily invested in bonds.

With the above principles in mind, Save More Tomorrow invites participants to pre-commit to save more every time they get a pay raise. By synchronizing pay raises and savings increases, participants never see their take-home amounts go down, and they don’t view their increased retirement contributions as a loss. Once someone joins the program, the saving increases are automatic, using inertia to increase savings rather than prevent savings. When combined with automatic enrollment, this design can achieve both high participation rates and increased saving rates.