Behavioral Finance Q&A with Shachar Kariv – Part 2

In the second half of a conversation with PLANSPONSOR, U.C. Berkeley Economics Department Chair Shachar Kariv discusses the importance of defining and driving “financial rationality” among workplace savers.

Shachar Kariv is the Benjamin N. Ward Professor of Economics and the Economics Department Chair at the University of California, Berkeley. Like other thought leaders, Kariv believes behavioral finance is redefining the way people save and invest money, especially for retirement.

He admits retirement readiness and decision theory aren’t exactly the standard fare for economists in his position—but the trillions of dollars Americans have saved in the form of tax-qualified retirement assets comprise a critical piece of the U.S. investing landscape, he says. Beyond this, it is vital for a healthy economic future that Americans save enough to take financial responsibility for themselves and their families in retirement.

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Finally—unlike economic challenges that so commonly break down by income quartile or political affiliation—everyone who hopes to retire one day, at any income level, must confront the difficult task of giving up resources today for the benefit of one’s future self.

 

Q: Why do you think the fields of financial services and retirement planning are only now getting serious about the role of behavioral psychology and decision architecture?

Well, these ideas have been around for a long time, but they are becoming more important in a world where financial services consumers drive their own choices and are presented with so much more choice and control than they had in the past.

The underlying ideas are not new. The first American Nobel Laureate in economics was the great Paul Samuelson, who worked for a long time out of the Massachusetts Institute of Technology. In 1947 he wrote a book called Foundations of Economic Analysis. Now, the titles of most books in our field tend to oversell the content in the book—but this is an apt title for the work Samuelson accomplished in his writing about modern economics and financial decisionmaking.

It remains foundational today—he basically laid the ground for what we talked about earlier as the Theory of Revealed Preferences. He sketched out some of the earliest models that we can use to see what people’s preferences are when it comes to allocating risk—and he was big on the idea of letting the data reveal this, of looking at people’s real historical choices and behaviors to distill or boil down their true preferences.

Moreover, he did something even more interesting for the context of this conversation. He suggested that many market participants—individuals and institutions—do not actually have any consistent risk preferences to reveal. This will be familiar to your plan sponsor and adviser readers. Some participants in plans are simply incoherent about their own financial situation, so they are unable to rationally or consistently solve the various trade-offs at work in financial decisionmaking. This is one of the challenges the defined contribution retirement planning model is running straight into today. 

Q: Is it right to assume that participants who struggle with defining their risk preferences will always do worse in the savings effort?

Not necessarily, and I’ll explain. One of the attacks most commonly leveled against economists and certain economic theories is that we make our judgements based on the assumption that the financial choices people make are driven by their rationality. I think this is unfair criticism, because any good economist knows people often rely on emotions or they simply make an uninformed choice when it comes to their finances. Solid economic theory takes this into account.

Another important thing to keep in mind is that, as economists, we’re not talking about rationality in the common usage—most people do not really know what economists mean when they talk about “rationality.” They equate the rational choice with the objectively best choice—but that is not what we are talking about in economics. The definition of rationality for economists goes like this: “You are a rational financial market participant if you have preferences that guide your behavior.”

You can see from this that an individual might have a preference that works against his ultimate best interest—for example he may take on less investment risk than he needs to have a good chance of funding an adequate income replacement ratio in retirement—but by our definition this does not mean he is irrational.

I think it is good in general for people to have reasons underlying their economic decisions, but having this element of rationality does not always or even generally mean that an individual will make the right or the best decision based on their objective circumstances. In fact, it can be more challenging to get a rational person on track in the retirement savings effort than it is to get an irrational person on track. If the former has strong psychological biases underlying his reason-driven decisionmaking, it will be hard for a plan sponsor or adviser to push him towards the more appropriate choice.

Q: Can you talk more about how this applies to the daily work of plan sponsors and advisers?

As you know, a lot of the ongoing theoretical work in behavioral finance and retirement plan services more broadly is dedicated to some form of the rationality question—and whether participants should have decisions made for them. This is an area where I am working with a firm called Capital Preferences to really build out a sensible approach for addressing this thinking in the real world of retirement plan administration. For us, the important step for plan sponsors and advisers to take is to try and define how rational their plan participants are, and then to think about what the answer might mean for important plan design decisions.

At Capital Preferences, we are able to deliver this type of an insight because of the careful construction of the "risk and ambiguity” games we use in place of things like portfolio risk questionnaires. In our games, we ask individuals to make a series of theoretical decisions, which are loosely structured like retirement investments. Importantly, we structure the series questions in the game so that, if a person is answering their questions in a rational way and according to a fixed set of principals held in the mind, there should be a pattern in their answers that bears this out.

I’ll give you an example. If you were a rational financial decisionmaker and you told me in one of these games that you preferred a given Portfolio A over another Portfolio B, and then you went on to tell me that you also preferred Portfolio C over Portfolio B, you should not then go on to tell me that you preferred Portfolio C over Portfolio A. When we run a person through a series of these tests like this, we very quickly start to see just how much inconsistency (i.e., irrationality) a given individual displays.

If I’m a financial adviser or a plan sponsor, and I see that you answer all these questions rationally, the question then becomes, does this person’s set of preferences line up with what I believe is their best interest? If so—great—but if not, are there steps I can take from a plan design or educational perspective that will better align one’s preference with one’s best interest?  

If a participant, on the other hand, displays a lot of inconsistency, we have to ask how we can help the individual better understand their own circumstances and their wants and needs. Then we can turn to aligning their rationality and their best interest.

Q: Do you think the movement of this thinking into the financial services mainstream will improve the defined contribution retirement system and lead to more retirement wealth?

There are a few observations we can make that would suggest improving economic rationality will boost retirement plan performance in general. I explain this by first noting that U.S. households with very similar demographic characteristics across metrics like age, location, yearly income and the number of family members—they tend to vary quite widely in terms of their current wealth and their perception of financial well-being or anticipated hardship in retirement.

The question is, then, how can we explain the wealth stratification when these families are working off the same income base and presumably are facing the same expense demands? Outside of academia people are satisfied to say one’s success in wealth accumulation will be determined by the quality of their financial decisions—in the end the people that make higher quality financial decisions will accumulate more wealth. This sounds like a good explanation—but academics like myself, we want to go deeper. What does it actually mean to make financial decisions that are of high quality?

It’s not a concept that is very well defined at present—not least because people have very different goals for how much money they would like to make and how much money they need to be “happy” or “successful.” The key insight we have found after running many of these risk and ambiguity analyses is that, even after we control for income levels and other important factors, our measure of economic rationality helps explain the wealth stratification in a way other factors can’t.  

“The scientific way of saying this: ‘One standard deviation from the mean score of consistency with economic rationality in our experiments is associated with 15% more household wealth.’ In other words, the more consistency one displays in financial decision making, the better off we would expect them to be.”

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