RPA2 Module 6

Question 1

Enumerate the propositions on which the behavioral finance view of markets and market efficiency is based.

Answer 1

(a) Informed traders face risk-aversion constraints in seeking to keep prices
efficient. The efficient market hypothesis (EMH) argues that well-informed, risktolerant investors keep prices at their “fair values.” When prices are sufficiently out of line to warrant action by investors, they act to move them back. However, there are limits to arbitrage, which may constrain price adjustments.

(b) The trading decisions of individual investors are biased because of biases associated with human behavior.
(c) The purchases and sales of individual investors are highly correlated. In other words, individual investors tend to buy and sell the same stocks at the same time. This herding effect by individual investors can push the prices of stocks in one direction in a significant manner.
(d) Individual investors, who are considered the uninformed investors, generate buy/sell imbalances that drive prices away from fundamental value.
(e) Over time, informed investors will drive prices back to fundamental value.

Question 2

Explain the contribution to the theory of behavioral finance by DeBondt and Thaler known as the overreaction hypothesis.

Answer 2

People overreact to unexpected and dramatic news events. As applied to stock prices, the hypothesis states that, as a result of overreactions, “loser” portfolios outperform the market after their formation. The researchers interpreted this evidence as indicative of irrational behavior by investors, or overreaction. Investors overreact to information about companies and drive stock prices to unsustainable highs or lows. When investors realize later that they overreacted to the news, prices return to their correct levels.

Question 3

Does behavioral finance say or imply that people can beat the market because of irrationality and behavioral biases?

Answer 3

No. Because of the irrationality and behavioral biases of other investors.

Such a claim is an often-made basic misunderstanding of behavioral finance. What behavioral finance says is that market prices and fundamental values can diverge because of psychology. Opportunities may be present as a result of this divergence; however, investment managers will not necessarily try to exploit the opportunities.

Why? Informed investors may not be willing to take the risk involved to try to
exploit these opportunities, or constraints exist that prevent them from doing so.

Question 4

What is contrarian investing?

Answer 4

The belief or investment theory that holds it is profitable to trade contrary to most investors.

This investment approach involves taking positions that are currently out of favor. The investing philosophy particularly espouses the investor overreaction hypothesis, which states that investors overreact to events in a predictable manner, overvaluing the best alternatives and undervaluing the worst. Those who practice the contrarian investing approach tend to favor low price/earnings (P/E) ratio stocks, which are often out of favor, rather than the often popular high P/E ratio stocks.

Question 5

What does the performance of professional investors seem to indicate regarding the efficacy of market efficiency?

Answer 5

That markets generally tend to be highly efficient.

When looking at data on the performance of mutual fund portfolio managers, the following statistics on performance should be noted:

(a) Approximately 70% of mutual fund managers underperform over a ten-year period, and 80% underperform over a 20-year period.
(b) Over a recent five-year period, only 6% of U.S. stock funds achieved a ranking in the top half for five consecutive 12-month periods.
(c) Over a period of 30+ years, of the 139 mutual funds in existence for the entire period, only 20 funds outperformed by two percentage points or more.
(d) Consider the consistency of performance of mutual funds over a recent ten-year period. Take the top 25% of large capitalization funds during the period 2001-2006. Over the subsequent five years, 2007-2011, only 12% of the earlier top performers were in the top 25%.
(e) As for institutional portfolios, research shows that after adjusting for risk, well under 1% achieve superior results after all adjustment for costs.

Question 6

Summarize some of the contrary evidence that researchers have found regarding market efficiency.

Answer 6

Some anomalies exist and may offer opportunities to astute investors.

Another example of contrary evidence involves the crash in stock prices that occurred in October of 1987. The Standard & Poor’s (S&P) 500 index lost over 20% of its value in a single day. With this occurrence, the question is posed as to whether it is reasonable to argue that investors, efficiently discounting information, decided in one day that the market should be valued at a level that was 20% below the prior day’s level.

Yet a third example of market inefficiency involves the Internet market bubble that burst in 2000. After climbing to exorbitant heights in 2000, the market significantly declined in value during the two subsequent years.

Question 7

Given the controversy involving market efficiency and research findings from
behavioral finance, what choice is left to investors?

Answer 7

Pursue an active investment strategy, a passive investment strategy or some combination thereof.

Making the choice depends heavily upon what the investor believes about
efficient markets. However, investors who plan, or wish, to pursue some type of active strategy should consider a quote attributed to Warren Buffett:

“Most investors, both institutional and individual, will find that the best way to
own common stocks (shares) is through an index fund that charges minimal
fees. Those following this path are sure to beat the net results (after fees and
expenses) of the great majority of investment professionals.

Question 8

How do the studies of behavioral finance and behavioral economics have
relevance to retirement plan design as the private retirement system places greater emphasis on defined contribution structures?

Answer 8

Behavioral finance and behavioral economics are fields of study that apply the use of scientific research techniques to understand social, cognitive and emotional biases that affect and influence economic decision making.

These fields of study concentrate on the decisions of individual and collective economic agents and study whether the decisions they make are entirely rational or seem to lack rationality.

Since the trend in retirement plan design has shifted to a defined contribution model where individual plan participants are largely responsible for making investment decisions and bearing the risk associated with those decisions, the field of behavioral finance is highly relevant to plan sponsors to understand the biases that may either help or hinder the decision making that will contribute to plan participant long-term economic security.

Question 9

As researchers have studied decision making in the newly emerging field of
behavioral finance, what are certain key themes that have been found within these studies?

Answer 9

HFM

(a) Heuristics: People often make decisions based on approximate, so-called rules of thumb that are not entirely grounded in strictly rational analyses. Shortcuts to decision making can result from difficulty in assembling all of the relevant information or from limitations on the decision maker’s capabilities or competencies. Therefore, decisions often fall short of the optimal positive determinations suggested by neoclassical economists.
(b) Framing: The way a problem or decision is presented will affect an individual’s action. The outcome then is sometimes less than optimal. Importantly, decision makers are influenced by the depiction of the choice, and their decisions appear to be susceptible to manipulation. This theme has both negative and positive implications. On the negative side, it suggests that economic agents’ decisions can be flawed and are far less reliable and logical than previously envisioned. On the positive side, however, is the potential promise that decisions framed differently can guide decision makers to make more optimal choices.
(c) Market inefficiencies: Market outcomes diverge from what would be expected if market efficiency was present. Real-life outcomes that previously appeared unexplainable by economic modeling are seen as explainable once social, cognitive and emotional biases are recognized. No longer must observable conditions in the real world be deemed unexplainable or mysteriously incongruent with logical economic modeling. The introduction of a more accurate portrayal of human economic agents explains market conditions

Question 10

What are some of the implications of the key themes enumerated in the previous question, particularly as they relate to retirement plan design?

Answer 10

individuals make decisions with incomplete information, are likely to be influenced by the way the decision is presented and make suboptimal choices as a result.

Although this model is one of suboptimal choice and inefficiency, it allows for the facilitation of better decision making by framing the decisions differently.

The application of behavioral finance is very appropriate in the context of selfdirected, defined contribution plan management. With these types of plans, individual participants are faced with the opportunity to make decisions that will enhance their long-term financial security. Essentially, the worker must choose to participate, to set a contribution rate, to select various investments and ultimately to decide how funds are withdrawn from the account. All of these decisions are complex determinations. With the shift from defined benefit plans to defined contribution approaches and, with the elements of defined contribution plan design that place many responsibilities for decision making on the individual participant, the study of behavioral finance and behavioral economics is very relevant to the
study and design of retirement plans.

Question 11

Discuss the findings of behaviorists on individual investment decision making,
specifically noting the two major categories of impediments that impede rational decision making in this area.

Answer 11

Some of these insights show a passive avoidance of decision making by individuals, while others show anomalies when individuals make active choices regarding investments.

Behaviorists have determined that individuals have certain proclivities and tendencies that forestall them from even approaching the subject and initiating action that is in their longterm interest. But even if individuals surpass the passive factors resulting in inactivity, their active choices are less than optimal and reflect certain active choice biases

Question 12

How does the fact that individual investors are loss-averse tend to be problematic for individual investors when making decisions about their retirement investments?

Answer 12

Research indicates that individuals suffer more remorse as a result of losses than they experience satisfaction or pleasure for their gains.

Essentially, individuals do not equally rate gains and losses of equal magnitude. It has been found that, on average, if a gain and loss were of the same magnitude, individuals felt more remorse for losses by a factor of two or 2.5 times the satisfaction felt for a gain. The implication of this finding is that convincing individuals to forgo present consumption for a future payment at a later date may be difficult. In short, it is a challenge from the outset to convince many individuals to save for retirement.

Question 13

Define what is meant by hyperbolic discounting and how it contributes to
participant inactivity in planning for retirement.

Answer 13

Apart from sheer loss aversion that results from forgoing current consumption, individuals tend to overemphasize immediate desires and rewards at the expense of their longer term needs. Not surprisingly, present needs consistently appear more pressing.

Hyperbolic discounting is the human tendency, when faced with
uncertainty, to sharply reduce the importance of the future in the decision-making process. Consequences that occur at a later time, good or bad, tend to have a lot less bearing on choices.

Survey results have shown that 25% of workers who have access to a defined contribution plan fail to contribute at all, while fewer than 10% will
contribute at the maximum level allowed under the law. Furthermore, consumption levels tend to progress upward as income levels increase. Individuals have a proclivity to spend more as they earn more.

Question 14

Are procrastination and inertia factors in impeding individual participant action
when it comes to retirement planning?

Answer 14

Yes.

Inactivity in decision making tends to have a “stickiness” that demands more effort to overcome once a decision is delayed, deferred or avoided.

Procrastination may result from a bias toward the status quo At times, a decision to maintain the status quo may make rational sense, but at other
times, particularly when the cost of a delayed decision is high, the preferential bias toward the status quo is clearly irrational.

For instance, when an employee is willing to forgo an employer match in a 401(k) plan, procrastination and inertia are clearly
irrational.

Question 15

Explain the circumstances under which preference for the prevailing condition
because of status quo bias is irrational.

Answer 15

Closely related to procrastination, and perhaps overlapping with procrastination and inertia, is status quo bias.

When comparing actively making decisions or taking a positive step or decisive move, individuals have a proclivity to prefer the status quo,
or the prevailing condition.

Status quo bias is not irrational when the decision is cost-neutral or when uncertainty is so pronounced that the likelihood of a gainful outcome is highly suspect or unsure. However, an ensured receipt of an employer matching contribution within a 401(k) plan is neither a cost-neutral situation nor an uncertain outcome. Quite the contrary: It is a delayed decision carrying a very high cost, especially when the effects of compounding are considered. However, the compounding effect is probably masked due to hyperbolic discounting.

Question 16

Describe the high level of complexity implicitly contained with decisions when
planning for retirement.

Answer 16

When individuals attempt to save, invest and plan for retirement, they need to make decisions under uncertainty. These decisions involve weighing a number of competing factors, assigning priorities to these factors, projecting certain trends and expectations into the future, and performing complicated computations to which individuals cannot easily intuitively assign values.

In short, even if a person desires to plan for retirement, reducing the problem to a manageable basis is not an easy exercise. In fact, many individuals find the nature of the decision to entail such complication that they need significant professional assistance to design their personal plan if they are to plan effectively.

Question 17

Summarize how the condition of choice overload can impact retirement choices.

Answer 17

When individuals approach this complicated decision, many times they are faced with a large and perplexing set of alternative choices. The decision is complicated enough, but the innumerable different possible scenarios and the proliferation of options within retirement planning structures expand the possible choices that individuals may select.

The sheer volume of choices, or choice overload, often serves to result in a “paralysis of analysis” and an inability to settle on a decisive course of
action.

Question 18

Are there limits on an individual’s ability or likelihood of making the most optimal choice when it comes to planning for retirement?

Answer 18

Even if individuals do not succumb to choice overload, the odds against making optimal choices are formidable, a condition known as bounded rationality.

Individuals have limitations regarding their mental capabilities to deal with
complexity inherent in retirement planning. The historical portrayal of economic agents assumed capabilities exceeding the skill set of many individuals.

Question 19

How do investors misjudge when they attempt to rationally review performance data in making investment decisions?

Answer 19

Investors seem to overweight past performance as an indicator of future
performance, particularly when reviewing the performance of mutual funds.

Funds routinely caution prospective investors that past performance is not a guarantee of future performance. Nevertheless, investors disregard this caution. Investors may be relying on the only information, or what they consider the best information, that they possess regarding a gauge of the fund’s performance.

However, all too often the investor is more likely to experience reversion to the mean in future years, rather than continued above-average performance by a given fund manager.

It also should be noted that fund families often heavily advertise those funds within their family of funds that have turned in a stellar performance. Many investors may be reacting to the advertising stimuli they are receiving to a greater extent, rather than making a reasoned determination as to where to best direct their investable funds.

Question 20

Discuss the concept of savings anchors and how they can adversely impact
decisions regarding the appropriate amounts to save for retirement.

Answer 20

Workers are deciding the appropriate level at which to save for retirement. This decision has enormous implications as to whether they will have sufficient resources to fund a comfortable retirement.

Savings decisions are subject to certain biases, and anchors involve an initial starting point or level from which the decision maker adjusts. When one examines the level at which individuals save for retirement, one can identify the starting points from which individuals begin their decision process.

Researchers have noted that so-called savings anchors vary with age and income. Those who are closer to retirement and possess higher incomes
appear to anchor their savings to the maximum allowed under the law.

Conversely, workers who are further from retirement and possess lower incomes tend to anchor their savings to the minimum level of contribution necessary to receive the full employer match. In both of these situations, it appears that the level of saving is affected more by the anchor and perhaps by affordability than by a computation of the necessary funds to sustain a certain income level during the retirement years.

Question 21

Do investors realistically assess their investing ability, or do they exhibit an
inflated assessment of their investing prowess?

Answer 21

Many investors have an undue level of confidence that contrasts with reality when it comes to assessing their personal record of investment success. Those investors whose investing records appear to be abysmal seem to indicate in surveys that they are the most confident about their investing abilities.

Researchers have found an inverse correlation between investor overconfidence and knowledge. In a retirement confidence survey, a significant percentage of those who were confident about their retirement were, in fact, not saving anything toward their retirement!

Question 22

Do peers appear to have some degree of influence when it comes to planning for retirement?

Answer 22

Peers seem to have an effect on whether individuals choose to participate in
retirement plan offerings. A study suggested the potency of peer influences by noting the high rates of participation in a retirement program within certain work groups at an employer. Peer effects would seem at odds with the view that saving and investing decisions are made by economic agents using a rational process.

Question 23

Do investors draw faulty conclusions when it comes to understanding the risk that inevitably accompanies an investment decision?

Answer 23

Investors underestimate the risk of certain investments. Such inappropriate risk discounting occurs when investors have familiarity with an investment. This is particularly true with company stock held in retirement plans. Although company stock fails to be a diversified investment and is even more risky since it is correlated with one’s source of income, individuals have repeatedly concentrated their 401(k) holdings in company stock.

This is risky since the individual may lose his or her job if the company experiences financial difficulties and simultaneously may see the
value of his or her retirement plan plummet

Question 24

Do investors seem to make effective decisions when it comes to disposing of
assets rather than when initially choosing to purchase them?

Answer 24

When it comes to selling or disposing of assets, individuals have biases against selling assets at a loss. They often liquidate assets that have appreciated and retain investments where the market price has declined.

This disposition effect does not mean that investors are rationally evaluating assets in terms of their long-term intrinsic value. Rather, many investors appear to be avoiding the regret they would experience in recognizing a loss. These investors show a propensity to hold onto some marginal or inferior investments while disposing of the more superior investments.

Question 25

Explain the following retirement plan innovations resulting from behavioral
finance findings: (a) lifecycle funds, (b) progressive increases in savings rates,
(c) automatic enrollment and (d) default investments.

Answer 25

(a) Lifecycle funds are mutual funds to facilitate asset allocation decisions based on the participant’s age. There are two basic types: static-allocation funds and targeted-maturity funds.

With the static-allocation approach, the funds maintain an established asset allocation. A series of funds are offered, with some funds
aggressive and other fund offerings having less risk. Investors determine which fund is appropriate given their individual risk tolerances. Individuals often use more aggressive funds at younger ages and transition into the less aggressive funds as they age and approach retirement.

The second approach offers a series of funds with target retirement dates
designated. An individual selects a fund with the approximate or exact year in which he or she expects to retire. Unlike the static-allocation funds, where an individual must actively choose to move to less aggressive funds as he or she approaches retirement, the targeted-maturity funds automatically rebalance and shift investments from aggressive to more conservative asset allocations as the target date approaches.

The final allocation as of the targeted date is often intended to remain intact throughout the retirement years.

(b) Under the progressive increases in savings rates approach (suggested by Thaler and Benartzi), decisions are made considerably in advance of pay raises to commit to increased retirement savings at those future times when pay is raised.
(c) The practice of automatic enrollment involves a requirement that an individual becomes a plan member when initially eligible unless the individual makes a negative election to the contrary to decline plan participation. This approach requires action by the individual to decline participation rather than the traditional approach that requires action in order to become a plan member.
(d) Default investments are closely related to automatic enrollment. A contribution into a defined contribution plan that is self-directed by the employee presents a problem. Once a contribution is placed in the plan, how should the contribution be invested? In the absence of instructions from the employee, should the employer make investments that were unlikely to sustain any losses? Or, alternatively, should an employer invest using asset classes whose historical rate of return would provide a superior long-term outcome, though possibly with greater volatility, resulting in investment losses in the short term? The passage of the Pension Protection Act of 2006 (PPA) brought greater clarity to this issue

Question 26

What notice requirements must a plan sponsor abide by to receive relief from
liability when investing participant assets in default investment alternatives?

Answer 26

If the plan sponsor is to receive relief from liability, each participant must receive, within a reasonable period of time before each plan year, a notice explaining the employee’s right under the plan to designate how contributions and earnings will be invested and explaining how, in the absence of any investment election by the participant, such contributions and earnings will be invested.

Additionally, participants must have a reasonable period of time after receipt of such notice and before the beginning of the plan year to make such a designation. Such a notice must be sufficiently accurate and comprehensive to apprise the employee of such rights and obligations, and it must be written in a manner calculated to be understood by the average employee eligible to participate. The relief provided by the regulation is conditioned on the use of certain investment alternatives.

Question 27

What are the six conditions to qualify for fiduciary relief when investing participant assets in default investment alternatives? accomplishes this.

Answer 27

(1) Assets must be invested in a qualified default investment alternative (QDIA). In order for an investment to qualify as a QDIA, five requirements must be met.

(2) The participant or beneficiary on whose behalf assets are being invested in a QDIA had the opportunity to direct the investment of assets in his or her
account but did not direct the assets.

(3) The participant or beneficiary on whose behalf an investment in a QDIA may be made is furnished a notice within a reasonable period of time (at least 30 days) in advance of each subsequent plan year. The required notice can be furnished in the plan’s summary plan description or summary of material modifications or as a separate notification.

(4) The terms of the plan must require that any material provided to the plan
relating to a participant’s or beneficiary’s investment in a QDIA (e.g., account
statements, prospectuses, proxy voting material) be provided to the participant or beneficiary.

(5) Any participant or beneficiary on whose behalf assets are invested in a QDIA must be afforded the opportunity, consistent with the terms of the plan (but in no event less frequently than once within any three-month period), to transfer, in whole or in part, such assets to any other investment alternative available under the plan without financial penalty.
(6) The plan must offer participants and beneficiaries the opportunity to invest in a broad range of investment alternatives as specified in the Section 404(c) regulation. The Department of Labor (DOL) believes that participants and beneficiaries should have access to a sufficient range of investment alternatives to achieve a diversified portfolio with aggregate risk-and-return characteristics at any point within the range normally appropriate for the retirement plan participant or beneficiary. DOL believes that the application of the broad range of investment alternatives standard to the Section 404(c) regulation accomplishes this.

Question 28

What are the five requirements for a QDIA?

Answer 28

(1) Generally, a QDIA shall not hold or permit the acquisition of employer
securities.

(2) A QDIA may not impose financial penalties or otherwise restrict the ability of a participant or beneficiary to transfer, in whole or in part, his or her investment from the QDIA to any other investment alternative available under the plan.
(3) A QDIA must be managed either by an investment manager as specified under the Employee Retirement Income Security Act of 1974 (ERISA) or by an investment company registered under the Investment Company Act of 1940. The regulation requires that, except in the case of registered investment companies, those responsible for the management of a QDIA be investment managers as defined by ERISA.
(4) A QDIA must be diversified so as to minimize the risk of large losses.

(5) A QDIA conditions relief on the use of one of three types of investment
products, portfolios or services. These three types of investment products,
portfolios or services include:
• An investment fund product or model portfolio based on the participant’s
age, target retirement date or life expectancy. An example of such a fund or
portfolio may be a lifecycle or target-retirement-date fund or account.
• An investment fund product or model portfolio with a target level of risk
appropriate for participants of the plan as a whole. An example of such a fund or portfolio may be a balanced fund.
• An investment management service where an investment manager allocates the assets of a participant’s account based on the participant’s age, target retirement date or life expectancy. An example of such a service may be a managed account.

Question 29

Describe (a) the disclosure requirements mandated by DOL that plan sponsors
must provide to all plan participants and beneficiaries if target-date funds TDFs) are offered under a defined contribution retirement plan and (b) the expanded, additional disclosures that were generally required for QDIA when the TDF requirements were instituted.

Answer 29

(a) DOL mandated that disclosures be made by plan sponsors to all plan
participants and beneficiaries if TDFs are offered under a defined contribution retirement plan. These disclosures must be made to the participants and beneficiaries regardless of whether or not the participants and beneficiaries have actually been defaulted into a TDF. Among the required disclosures are:
• An explanation of the TDF’s asset allocation, how it will change over time and the point at which the investment will reach its most conservative asset
allocation, including a chart, table or other graphical representation.
• An explanation, if the fund by name includes or implies a target date, of the age group for whom the investment is designed, the relevance of that date, and any assumptions about a participant’s contribution and withdrawal
intentions on or after such date.
• A statement that the participant may lose money by investing in a TDF,
including losses near and following retirement, and that there is no guarantee that the investment will provide adequate retirement income.
(b) In addition to the disclosure requirements mandated for TDFs, DOL required expanded, additional disclosures for qualified default investments. Among these expanded, additional disclosures were:
• The name of the QDIA issuer
• The investment objectives or goals
• A description of the investment’s principal strategies and risks
• Historical performance data and, if applicable, any fixed return, annuity,
guarantee, death benefit or other ancillary features
• A statement indicating that an investment’s past performance is not
necessarily an indication of its future performance
• A description of fees and expenses, including those charged directly against the amount invested in connection with acquisition, sale, transfer or
withdrawal (e.g., sales loads, sales charges, deferred sales, surrender charges, redemption fees, exchange fees, account fees and purchase fees) of any annual operating expenses (e.g., expense ratio) as well as any ongoing expenses in addition to annual operating expenses (e.g., mortality and expense fees).