In this course, you will start by reviewing the fundamentals of investments, including the trading off of return and risk when forming a portfolio, asset pricing models such as the Capital Asset Pricing Model (CAPM) and the 3-Factor Model, and the efficient market hypothesis. You will be introduced to the two components of stock returns – dividends and capital gains – and will learn how each are taxed and the incentives provided to investors from a realization-based capital gains tax. You will examine the investment decisions (and behavioral biases) of participants in defined-contribution (DC) pension plans like 401(k) plans in the U.S. and will learn about the evidence regarding the performance of individual investors in their stock portfolios. The course concludes by discussing the evidence regarding the performance of actively-managed mutual funds. You will learn about the fees charged to investors by mutual funds and the evidence regarding the relation between fees charged and fund performance. Segments of the portfolios of mutual funds that may be more likely to outperform and examples of strategies designed to “earn alpha” will also be introduced. Learners are welcome to take this course even if they have not completed "Investments I: Fundamentals of Performance Evaluation," as the first module contain a review of investment fundamentals and regression analysis to get everyone up to speed. Also, the course contains several innovative features, including creative out-of-the-studio introductions followed by quick-hitting "Module in 60" countdowns that highlight what will be covered in each module, four "Faculty Focus" interview episodes with leading professors in finance, and a summary of each module done with the help of animations! This course is part of the iMBA offered by the University of Illinois, a flexible, fully-accredited online MBA at an incredibly competitive price. For more information, please see the Resource page in this course and onlinemba.illinois.edu.
2-1.5. Naïve Diversification
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From the course by University of Illinois at Urbana-Champaign
Investments II: Lessons and Applications for Investors
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University of Illinois at Urbana-Champaign
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Course 4 of 7 in the Specialization Financial Management
From the lesson
Module 2: Investment Decisions in DC Pension Plans
In Module 2, we discuss the investment decisions of participants in defined-contribution (DC) pension plans like 401(k) plans in the U.S. Not falling prey to common behavioral biases is key to sound financial decision-making in these retirement plans, so we will discuss common behavioral biases of DC pension plan participants.
Meet the Instructors
Scott WeisbennerWilliam G. Karnes Professor of Finance
Department of Finance, College of Business
[MUSIC]
All right, next on our countdown here.
Let's talk about naive diversification or so-called 1/N investing.
So what's the idea behind naive diversification?
Well the simple idea is participants are influenced by the composition
of investment choices, even if these choices are duplicative.
So this is discussed in a work by Benartzi and Thaler.
And some work that I have done as well.
You can also view this as being consistent with an endorsement effect that we've also
discussed in the module.
The simple idea is, if you see a lot of stock funds in the plan.
Even if a lot of these stock funds are very similar in investment style,
people may view that as a signal, like wow it's good to invest in stock.
So let me invest a lot of my portfolio in stock.
If there's a lot of bond funds in the plan they may interpret that as like,
hey I should invest a lot in bonds.
Even though that is not the intent at all of the plan provider, okay?
So two methods to test whether this framing leads
to naive diversification in portfolio decisions.
One method would be do an experiment or survey.
Benartzi and Thaler kind of do that, so
let's give people various menus of investment options,
hypothetically and see how they would then, hypothetically, invest.
Another is to actually look at the decisions of actual people.
Look at data from, thousands of firms.
See what options are available to plan participants, and then how do they invest.
Plan participants at firms that have a lot of stock options,
do they put more in stock?
Those that have more bond options, do they put more in bonds?
And that's kind of the method that I pursue with my co-authors.
So let's consider three hypothetical sets of options to
illustrate how these three plans may lead to very different investment
patterns by participants, if participants are subject to naive diversification.
And this is actually an experiment I've done in several of my classes teaching
MBA and MSS students, as well as executive MBA students.
So fund one or Option 1 Has four bond funds, and two stock funds.
So, Option 1 has 4 bond funds and 2 stock funds.
Money market fund, long term US bond, medium term US bond,
short term US bonds, S&P 500, and NASDAQ index.
Option 2, 2 bond funds, 2 stock funds, and a 50/50 balance fund.
Money market, long term US bonds, S&P 500, NASDAQ, and
then this balance fund, which is 50% stocks, 50% bonds.
Option 3, 2 bond funds, 4 stock funds, so money market funds,
long-term US bonds, S&P 500, NASDAQ.
Then we have a large stock fund and a growth stock fund.
So you can see these options have different funds in them,
but they all kind of have the same type of investments available.
Like Money Market and short term US Bonds are kind of similar investments,
as are long term US Bonds and medium term US Bonds.
Growth Stock Fund and NASDAQ would probably perform somewhat similarly,
S&P 500 stock fund, and a large stock fund,
S&P 500 is large stocks, would also perform similarly.
So as we go from the 2 bond funds to the 4 bond funds,
it's not like our investment opportunities have really expanded that much.
The same as you go from 2 stock funds to 4 stock funds.
It's not like our investment opportunities have expanded that much.
So you really can get the same, I would guess,
reward to risk trade-offs across all three of these plans.
Okay, so what are the hypotheses, if we're looking at these three plans,
Option 1, Option 2, and Option 3?
If the agents are perfectly rational, we would expect them,
out of equity investment across the three plans, to be roughly the same, right?
Because they all have basically the same investment opportunities in the bond
space, in the stock space.
In a behavioral finance perspective, naive diversification would say,
as we look at Option 3, you're going to see more investment equities,
because there's simply more stock funds.
When we go to Option 1,
we're going to have more investment in bonds Because there's more bond funds.
Okay, so what are actually the predictions that we would see as in terms of
the percent of the assets invested in equity or stocks across these three plans.
Well the rational agent predictions see if we give these plans to people randomly,
we should see on average about the same equity allocation across all three plans,
okay?
Now the behavioral or naive diversification prediction is
we should see a dramatic change in the equity allocation.
We're going to see much more stock investment in the plan that has 4 stock
funds and much less in those that only has 2 stock funds.
Now I've done this experiment here many years for the MBA and MSF audience,
it kind of works like clockwork.
That you'll see this Option 3, people that were given this will invest about
30 to 35% more on stock than those that are granted plan 1.
Now, when I do it with an executive MBA group, I see smaller differences.
There still might be a slight tilt toward more equity and
plan 3 here that has 4 stock funds but the difference relative to the plan that
has two stock funds might only 10% each points, as supposed to the 30% or 35%.
But of course, the executive MBA group is a very select audience with a lot of
financial experience.
So it's not surprising that they may be less subject
to this naive diversification bias here.
So you can also think, besides looking at this experimentally, to look at
the mix of options and allocations and contributions for actual plans, okay?
So in the work that I have done with Jeff Brown and Nelly Liang we examined the data
for roughly 1000 publicly traded companies over 1991 to 2000.
We're going to look at the type of plan options provided by the firm, like your
own company stock, US equity funds, bond funds, international funds, etc.
Then we're also going to look at the investment decisions of participants.
How do they allocate their own contributions across these various funds.
And in particular, how does a contribution of plan funds,
which is the firm decision, how many stock funds, how many bond funds.
And the composition of allocation investment decisions,
which is decided by the worker.
How does that vary with the number of options in the plan?
So let's look at some of these results here, and
we're going to look at this by investment options.
So first we're going to look at fund options and
contributions for employer stock.
The, I guess, purple line here with the diamonds is showing the share
of fund options as a total number of options in the plan griows.
So company stock by definition is one option.
So if there's four options in the plan, 1 over 4 is 25%.
If there's 10 options in the plan, 1 over 10 is 10%, okay?
So not surprisingly, if there's more options in the plan,
the share options that are company stock is declining.
Okay, that's a definition.
How about the share of contributions?
Now this is controlled by the participants.
How much do you invest in company stock?
You can see this is the pink line with the squares here.
So you can see that as you increase the number of options in the plan,
you see participants are investing less in company stock.
That would be consistent with a naive diversification.
I put more in company stock if it's 1 out of 5 options than if it's 1 out of 10.
So how you set up the plan actually influences a company's stock investment.
And if you have more options in the plan,
people tend to invest less in company stock.
Now you can see this pink line is above the purple line.
That could actually represent familiarity bias, right?
Like controlling for how many options there are in the plan.
We see people investing more in company stock
than the simple naive diversification prediction.
That could just represent the familiarity bias
that causes people to like to invest in company stock.
But what's interesting is the share of investment to company stock is declining
as there's more options in the plan.
Now how about domestic equity fund.
So this is where we're talking about a sample of US pension plans.
So this is looking at investment in US stock funds.
So interesting pattern here, as the plans get bigger with more options,
the share of options that are equity funds actually increases.
And this is a choice by the firm.
So, if you have 5 options About 30% are stock funds, excluding company stock.
Right, our broad stock funds.
You get up to, 12 plus options almost 50% of the choices are stock funds.
So as the plans get and bigger,
the marginal investment option added as a stock fund.
Well what does that lead to?
Well you see that as the plans get bigger with more options,
not only are the share of options in the plan that are stock funds increasing.
So are contributions from participants to the stock funds.
So there's an adding up constraint.
If the share of funds and the share of allocations of contributions to stock
funds is going up as the number of options in the plan goes up, for bonds,
you have to have a declining relationship, right?
because everything has to add up to 100%.
So as the number of options in the plan increases,
the share of fund options, this purple line with the diamonds,
that are going into fixed income funds, is declining.
If you have 5 options in the plan, 35% of the options are fixed income or
bonds, it's only 25% if you have 11 options in the plan.
And likewise, you see contributions to bonds decreasing as the number
of options in the plan increases, which is typically happening over time.
So there is this kind of interesting result as options get bigger, the marginal
option added to the plan seems to be a stock fund as opposed to a bond fund.
If people are subject to naive diversification,
that might be tilting participants to riskier portfolios.
It's fine if that's what the risk aversion of the worker suggests is appropriate.
But if this is just due to psychological naive diversification,
then that's maybe somewhat problematic.
And then finally lets look at international funds.
So international funds are a small part of the portfolio.
So if you have 10 options in the plan, 10%, or
1 out of 10 of that 10, will be in international funds.
So not surprisingly, as the number of options offered by the plan
increases you start start to see, okay, maybe we add 1 international fund.
And then you see a little up-tic in share of contributions that are going into
international funds as the number of options increases.
Because hey you may go to 0 international funds to 1 international fund.
Now, for international stock it's like a negative familiarity bias, right?
So, people may invest more in company stock because they're familiar with it.
They may invest less in international stock funds,
because they're less familiar with it, and you actually see this in the chart.
You look at the actual contributions,
they're actually less than predicted by the naive diversification line here right?
The share of contributions, the pink line is less than the share of fund options.
The purple line with the diamonds, that represents this negative familiarity bias.
Kind of the opposite of what we had for company stock.
So, why is this potential issue or concern?
Over time, whether you use the kind of data that Jeff Brown, Nellie Liang,
and I had, or you augment that with data from Utkus and Young's work.
You see there's a clear increase in the number of investment options and
plans over time.
And then you might want to take into account if you have target date funds,
balance funds that are set up for people retiring at different ages,
20-30, 20-35, 20-40, 20-45.
Do you count this series of life cycle funds or target date funds,
do you count them as one fund?
Or do you count them as five funds?
That's why you have this difference in the light blue bar or the dark blue bar.
Regardless of how you want to measure them, as one group of funds, or
five separate funds, you still see this increase in fund options over time.
From a rational perspective, more options are good, but
from a behavioral perspective, that might not be the case.
Okay, is this too much choice for participants?
We'll talk later in the module about work of the potential consequences of choice
overload, in terms of how more choices affects participation in the plan.
When we have all these extra choices, what are these extra choices?
Are they more likely to be stock funds or bond funds?
This could have endorsement effect and naive diversification concerns.
Just to give you a little personal anecdote, in June of this year,
I looked at my 403B plan, It had 206 investment options.
The first 128 listed were stock funds.
The last 37 were bond and money market funds.
So there might be some potential for
framing people to invest a lot in stock funds.
Now on the other hand, Huberman & Jiang have a paper that naive diversification
effect is less in plans with many options than it is with less.
But I was just struck when I was looking at my own 403 B plan, like wow,
there's 206 choices and literally the first 128 listed are all stock funds.
So I saw the potential for
framing investor behavior, the way the plan was laid out.
Okay, and really, just philosophically,
do we need 25 plus options for an efficient frontier?
Like, okay, maybe we have a few bond funds, an S&P 500 fund,
maybe a small stock fund, maybe an international fund.
So maybe you can have 6 or 7 funds and cover a lot of different asset classes.
Do you really need over 25 options?
Or are you starting to get some duplicative choices in the plan?
Okay, now despite having all these investment options, over half of plans
covering over 40% of participants don't provide a basic core of index funds.
And by core of index funds, I mean index funds for U.S. equity U.S.
bonds and international equity.
So kind of a trio here, so what does this mean?
It means that, hey, there's a lot of actively managed fund options
which typically have much higher expense ratios in the plan.
With more index option choices and
more prominent display in the menu it can help lure participant expenses.
Another issue is, if you have like 30 options and only 2 or
3 are index funds, even if the person wants them, they may be hard
to find when you have this list of all these many, many options, okay?
So let's think about
a question here, to wrap up this video.
So related to naive diversification,
why do pension plan participants, behave this way?
Why should we care about it, okay?
And how should firms respond to this bias in decision making?
So we're ending here with some you know really philosophical, okay,
the big picture questions.
So why don't you think about it, and then I'll give you my take.
Naive diversification.
Why do pension participants seem to behave this way?
Well, if you think about it, investments and
retirement plans, 401K plans, is investment for the masses.
A lot people haven't had any financial training.
Even if they have,
they're still likely maybe subject to some psychological biases.
And I think it's very reasonable if you look at a plan and you see,
wow, so many of the options are stock, its probably reasonable to invest in stock.
But you just want to be sure that that's reasonable for
you given your stage in life and your willing to take on risks.
Make you financial choices based on your own risk aversion and
your situation in life, not how the choices are presented to you in the plan.
Why should we care about it?
Well we want people to be making allocations,
financial decisions, based on sound economics.
Not on how things are framed to them or
misinterpreting how things are framed as providing advice, okay?
So, participants may think, the firm is giving me so many stock options,
or is giving me so many bond options, they must thing those are good investments.
The firm, maybe they were just looking at the available options, and
the salesmen from the mutual fund company emphasized some stock funds.
Okay, maybe that firm wasn't trying to send any signal at all.
How should the firms respond to this bias in decision making?
So if firms know when setting up their 401K plan
that people are subject to naive diversification
it suggests to be careful in the mix of options you have in the plan.
If you want to minimize company stock investment,
you can do that indirectly by having a big number of options.
We saw that result.
Also, you want to think of what's a good allocation between stock and bonds for
the typical person.
And you might want to have your share of options that are stock
funds versus bond funds be something close to that.
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