2-1.6. Inertia

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From the course by University of Illinois at Urbana-Champaign

Investments II: Lessons and Applications for Investors

364 ratings

University of Illinois at Urbana-Champaign

Investments II: Lessons and Applications for Investors

364 ratings

Course 4 of 7 in the Specialization Financial Management

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.

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.

2-1.1. Overview of Key Biases in Decisions9:32

2-1.2. Representativeness4:29

2-1.3. Familiarity Bias and Background Risk22:22

2-1.4. Endorsement Effects7:27

2-1.5. Naïve Diversification18:47

2-1.6. Inertia4:58

2-1.7. Option Confusion5:36

2-1.8. Power of Defaults16:19

2-1.9. Bottom Line on Biases in Investment Decisions7:53

Meet the Instructors

Scott Weisbenner
William G. Karnes Professor of Finance
Department of Finance, College of Business

[MUSIC]

All right. So now let's talk about inertia.

And what do I mean by inertia?

It's always good to show a picture if you can.

A picture's worth a thousand words.

So if you ever heard the phrase, let a sleeping dog lie.

So I thought, why not get my dog Max.

In the neighborhood, I'm known as the guy with the dog,

walking my beloved Siberian Husky, Max.

He gets compliments 80% of the time we walk.

I'm yet to get a compliment.

But anyway, it's good to be in his company.

He's not sleeping here, but it looks like he doesn't want to go any place soon.

So I'd call this Inertia.

Now, inertia can be good or bad.

For example, if we're about ready to have a meal, and

if Max is comfortable being here on this bed.

By the way, which is my son's, Luke, and he's rarely getting in Luke's room.

So he took this opportunity to jump on Luke's bed.

If Max is going to stay here while we are eating,

this could actually be good inertia, right?

He won't be bugging us to give him food while we are trying to have

a peaceful meal.

On the other hand, if this is five minutes before Luke is going to go to bed,

this is bad inertia because it's going to be very awkward to try to get Max

down from the bed and then get Luke into the bed.

So, point is inertia can be good or bad.

Same thing is true when it comes to investments and

located inertia in financial decisions can be good or bad, right?

Depends on what your initial decision if you're sticking with it,

well that's good, right?

But if your initial decision was bad and

you're sticking with it, that's not so good.

Okay, so this really highlights the importance

of participants making a sound portfolio allocation at the start.

I'm about to show you a study that just documented

the inertia that people have in their financial decisions.

So if your first decision is good, it's okay to have this inertia.

It also explains the powers of defaults,

which I'll talk about later in the module, in influencing behavior.

So default policy is what choice are you put in to if you don't make a choice?

And if that default is good then it's good for you to say there, but

if it's bad, it's not so good.

Like if you ever signed up for some service,

like you're getting a magazine, or you're checking your credit score, and

you clicked this box, it says like, hey, charge many a month.

I can cancel when I want.

Why do companies set up that way?

because people forget to cancel and then they get charged month after month,

after month.

So that's a case where inertia is working against you, but it's working for

the magazine company.

Or the company that wants to sell you, you know,

kind of telling you want your credit score is.

Let's think of kind of a financial example here, and how about this is a module

about retirement plan investing, so let's look at this Ameriks and Zeldes study.

They examine decisions of TIAA-CREF participants in their

retirement plan over a nine-year window And look, were there any changes?

Did these people make any changes in their investment decisions?

And there are two decisions participants could make.

One is just simply, what's the asset mix?

What fraction in stocks, what fraction in bonds?

We call that asset allocation.

The second decision is what's your contribution allocation.

So forget your existing assets.

For new money you contribute to the plan,

what's going to be the mix of bonds or stock.

So two separate decisions.

What did people do, what are the results of the study?

47% made zero changes to their

contribution allocation over a 9-year period.

68% made zero or one change, so the initial allocation,

100% stocks, 50% stocks, 80% bonds.

People generally stick with that, or very rarely revisit it.

73%, three-quarters made zero change to the asset

allocation over the nine-year horizon.

And 86% made zero or one change.

So even stronger evidence that people are sticking with this initial allocation.

So this research really highlights how important inertia is in financial

decisions, and it also highlights how important default policy is.

If you have the default, and people are in something defaulted into something good,

they'll probably stay in that good thing.

But if you have the default that people are to default into something bad,

like the bad thing can be not saving.

Or saving but saving in an inappropriate asset allocation, that's bad because of

this inertia that people clearly exhibit in their financial decision making.

[SOUND]

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