Why Poor Investment Decisions - cont

fourth explanation:
Anchoring, the Status Quo, and Procrastination

• Retirement plans
– Failing to change risk allocations
– Arbitrary options influence risk allocations
• Sticking to the status quo
• Failure to “opt-in”
 Why Poor Investment Decisions - cont
fourth explanation:
Anchoring, the Status Quo, and Procrastination

- Though we have just reviewed evidence

suggesting that investors take excessive action
by trading too frequently,
- there is evidence that in the domain of
decisions on allocating risk and whether one
should invest at all, people are not active
enough.
 Why Poor Investment Decisions - cont
fourth explanation:
Anchoring, the Status Quo, and Procrastination

- People should change their tolerance for risk as

they age and their financial circumstances
change, but they rarely change the allocation of
risk in their retirement plan.
 Why Poor Investment Decisions - cont
fourth explanation:
Anchoring, the Status Quo, and Procrastination

- Professors investing in retirement plans tend to

allocate half of their money into bonds and half
into stocks.
- However, the majority of professors never actually
change their allocation even though their risk
preferences should change over time.
 Why Poor Investment Decisions - cont
fourth explanation:
Anchoring, the Status Quo, and Procrastination

- Evidence from another study suggests that people

automatically allocate their funds evenly between
the options that they are presented with as a
simple investment heuristic.
 Why Poor Investment Decisions - cont
fourth explanation:
Anchoring, the Status Quo, and Procrastination

- So, if a company offers four retirement funds, many

employees are likely to evenly allocate their money into
each fund.
 Why Poor Investment Decisions - cont
fourth explanation:
Anchoring, the Status Quo, and Procrastination

- The problem with this is that

allocations of risk become influenced
by the arbitrary options that are
available.
- Essentially, the options available
influence the allocation of risk,
even though it may not be in line
with actual risk preferences.
 Why Poor Investment Decisions - cont
fourth explanation:
Anchoring, the Status Quo, and Procrastination

- People often fail to reconsider their risk allocations

because they tend to stick to the status quo.
- To test this, one experimental study used a hypothetical
scenario about inheriting a large sum of money or a large
financial asset.
- People who inherited money were given four investment options
with different degrees of risk.
- People who inherited an equivalent financial asset were asked
whether they would keep the investment or reinvest it into one of
the other three investment options.
- People overwhelmingly chose to keep the asset in its current form
despite the fact that their decision may have been different if they
inherited cash as opposed to a financial asset.
 Why Poor Investment Decisions - cont
fourth explanation:
Anchoring, the Status Quo, and Procrastination

- In addition to failing to reallocate risk in line with

changing preferences, people also frequently fail to
invest in the first place.
- This often occurs when companies have “opt-in” 401(k) plans
where employees must make a phone call and sign up for a
retirement through their company.
 Why Poor Investment Decisions - cont
fourth explanation:
Anchoring, the Status Quo, and Procrastination

- However, when companies have “opt-out” 401(k) programs

where employees are automatically enrolled in a plan and
must take action to exit the plan, the majority of people tend
to stick with the default 401(k) plan offered by their company.
- This may suggest that people simply procrastinate and fail to
put in the effort to invest even though they seem to have no
problem with investing when it is a default option.
- Procrastination and failing to adjust from a status quo of not
investing can cause people to miss out on opportunities to
earn high returns to their excess cash.
 Why Poor Investment Decisions - cont
fifth explanation:
Prospect Theory, Selling Winners, and Keeping Losers

• Selling winners
• Keeping losers
• Impact on returns
 Why Poor Investment Decisions - cont
fifth explanation:
Prospect Theory, Selling Winners, and Keeping Losers

- As we learned from prospect theory and

framing,
- people tend to be risk-seeking in the domain of
losses and risk-averse in the domain of gains.
Not surprisingly, this has important implications
for financial decision-making.
 Why Poor Investment Decisions - cont
fifth explanation:
Prospect Theory, Selling Winners, and Keeping Losers

- People tend to sell stocks that have earned positive returns.

- A big reason for this is that they form a reference point consisting of the
price at which they purchased a stock.
- When a stock earns positive returns above its purchase price, people
view subsequent fluctuations in price as falling within the domain of
gains.
- Because they possibility of losing value by holding onto the stock looms
larger than the possibility of continuing to earn positive returns by
holding onto the stock,
- people tend to be risk-averse and sell winning stocks out of fear that
their value will drop.
- Consistent with this argument, the more stock performance improves,
the more likely people are to sell.
 Why Poor Investment Decisions - cont
fifth explanation:
Prospect Theory, Selling Winners, and Keeping Losers

- People also tend to keep stocks that have earned

negative returns.
- Given that people use their purchase price as a reference
point, they view stocks that decline in value as losses.
- Because the chance to break even looms larger than the
possibility that the stock may continue to lose value,
- people tend to be risk-seeking and hold onto the stock
out of hopes that they can break even
- and avoid feeling regretful for selling the stock and then
seeing it rise in value.
 Why Poor Investment Decisions - cont
fifth explanation:
Prospect Theory, Selling Winners, and Keeping Losers

- Because investors have to pay fees for each

trade and taxes on each winner that they sell,
this practice of trading winners and selling
losers often results in excessive trading and
high taxes on the sale of winners, which serves
to reduce overall returns.
 section
Active Trading
 Active Trading
• The rise of online trading
• Initial success stories
• Underperforming the market
• Considering other traders
 Active Trading - cont

- When the advent of online trading dramatically

lowered the cost of trading in the 1990s,
frequent trading became more common.
- Some of the first online traders were people
who had recently outperformed the market
and the market at the time was quite favorable.
- This instilled many with the confidence to quit
their jobs and engage in day trading.
• day trading : means
• buying & selling in the same day
 Active Trading - cont

- However, day traders quickly started

underperforming the market due to their
excessive trading.
- Those who did earn income were taxed heavily on
this income.
- As a result, many people who quit their jobs out of
hopes of earning lucrative amounts of money from
trading ended up broke.
 Active Trading - cont

- One other reason that so many people may

have decided to day trade is that they likely
neglected the competition.
- The bulk of trades are conducted by sophisticated
institutional investors.
- If traders had considered the competition, they
may have realized that there was no good reason
for them to believe that they could outperform
these sophisticated investors.
 section
Action Steps
 Action Steps
• Determine your investment goals
– Save enough for retirement
– Embrace risk now
– Reduce risk later
– Invest in annuities
• Difficulty predicting the stock market
• Putting this information to use
– Avoid unnecessary fees
– Consider tax issues
 Action Steps - cont

- All of the information contained in this chapter

suggests several action steps that should be
taken to improve the quality of your financial
decision making.
 Action Steps - cont

- First, you should determine your investment

goals so that you can appropriately spread out
your risk over time.
- As we saw earlier, people fail to reallocate their risk
over time and their decisions are often inconsistent
with their true risk preferences.
 Action Steps - cont

- People often do not save enough for retirement

because they fail to take enough risk when they are
younger.
- By investing more into stocks when they are young,
people will likely experience a lot of fluctuation in
the value of their assets, but over the course of a
lifetime, they are very likely to come out ahead.
 Action Steps - cont

- However, as people age, they should become more

risk-averse, as they should have earned a sufficient
amount of money to live off for the rest of their
lives and not need additional funds.
 Action Steps - cont

- In order to better manage their money and ensure

a consistent flow of income after retirement, it also
may be a good idea for people to invest in
annuities.
- These involve paying a large lump some in exchange for
a steady flow of income for the rest of one’s lifetime.
 Action Steps - cont

- The strategy of investing in an annuity can be a losing

proposition of one dies at a young age, but in this case,
the individual does not need money anyways.
Additionally, those who live longer than expected will
earn more from the annuity than they invested into it.
 Action Steps - con

- We also have reviewed a lot about how difficult it is to

predict the stock market.
- The biggest reason the stock market is so difficult to
predict is that:
- people are essentially betting on what they believe others
will believe about the future performance of stocks.
- Because stock values are dictated by supply and demand,
accurately predicting the future value of stocks requires
accurately anticipating how others will value the same
stocks.
 Action Steps - con

- Thus, it is difficult to anticipate stock values

since everybody is constantly changing their
beliefs to adjust for what they believe all other
investors believe.
- This is why passively investing in an index fund
may be the way to go.
 Action Steps - cont

- By investing in index funds, people can avoid

accumulating fees from excessive trading
resulting from active management while
earning a higher return.
- However, it is important to account for tax
considerations before taking the advice here
into account.
 Action Steps - cont

- Tax policy changes over time and varies from

state to state, so it is difficult to recommend an
optimal investment strategy without having a
full understanding of how earnings will be
taxed.
 Action Steps - cont

- However, by being equipped with the

information in this chapter, hopefully you can
learn to improve the quality of your financial
decision-making.