In 2006, a study of Wharton MBA and Harvard college students’ decision-making in mutual fund investing was conducted. The authors presented subjects with four mutual funds that were all substantially similar: tracking the S&P 500 index of leading companies.
Respondents were asked to choose a fund in which to invest $10,000. The findings showed that the majority of students responding failed to look to minimize fees, which was the only differentiator between the funds. Bear in mind that members of this group were in the top 2% of student performers in the country, were studying business and could be assumed to be much more financially capable than the population as a whole.
So, even people with an elite business background may make elementary mistakes in investment fund selection. In fact, there is evidence to suggest that lower-income and less educated groups, while not necessarily investment savvy, are actually very competent at managing their money, in the form of daily and weekly budgets.
Certain behavioral biases affect everyone to some extent. The American economist Harry Markowitz once explained how he picked his university pension fund portfolio: “I should have computed the historical covariance and drawn an efficient frontier. Instead I visualized my grief if the stock market went way up and I wasn’t in it – or if it went way down and I was completely in it. My intention was to minimize my future regret, so I split my [retirement pot] 50/50 between bonds and equities.”
Markowitz exhibits a couple of things to note. The first is naive diversification – asset allocation based on rules of thumb that leads to less than optimal results. He also displays regret bias – taking a decision so as to avoid future regret.
Risk averse or risk seeking?
In the UK, the introduction of automatic enrollment into a pension scheme, starting from 2012, means that there will be a large influx of new pension savers with different characteristics than traditional investors.
The National Employment Savings Trust’s (
NEST) future members are likely to have less familiarity with financial products than existing savers. Those with pensions currently are more likely to have higher levels of savings and work in managerial or professional jobs. They are also likely to have a higher level of formal education and be older. The average risk capacity of the new target group is considerably lower than that of those currently saving into a pension.
Furthermore, research shows that our target group is more risk averse than risk seeking, with a large proportion (37%) favoring taking no risk at all with retirement savings. Risk preferences also trend by income, with those on lower incomes more likely to be risk averse than those on higher incomes. Our research showed younger people have some of the strongest reactions to investment loss.
The research showed that the target group is likely to have negative and emotional responses to investment loss. Participants were disappointed, angry, surprised and incredulous when confronted with hypothetical investment losses. Loss was also felt with a sense of immediacy and was not considered within the context of long-term savings. Loss aversion was observed most strongly among the young (who were often the most risk seeking) and those on low incomes. This was more likely to translate into stopping contributions.
Get people saving
When we look at designing a default approach for members – NEST’s Retirement Date Funds – there are three areas of risk in tension with each other: risks that people want to take (risk appetite), risks people can take (risk capacity) and risks people need to take to deliver a retirement income. The challenge for developing the default investment approach for NEST has been to balance these.
Our approach may look a little different from that taken by many workplace schemes because our target audience is not the typical market for pensions. We need to manage our members’ exposure to risk to encourage them to save regularly and build up retirement savings over their working life. The key aim is to get people saving and keep them saving.
Younger members will experience three phases of investing, starting with a Foundation phase for those in their 20s, where we will target investment returns that look to match inflation after all charges have been taken out. It’s a lower risk start than traditionally advocated in defined contribution schemes but members won’t spend long here – they’ll spend the vast majority of their time with NEST in the Growth phase, which introduces higher levels of risk gradually and targets returns of inflation plus 3% after charges. This phase will last, on average, for about 30 years, before we move into a Consolidation phase to reduce exposure to return seeking assets and match members’ planned method of taking retirement benefits.