Behavioural Economics and Finance presented at the Malta Association of Risk Management (MARM) Conference of 15 March 2013 by Professor Liam Delaney

1. Behavioural Economics and Finance
Professor Liam Delaney,
Stirling, SIRE and UCD Geary Institute
Malta Association for Risk Management Workshop
March 15th 2013

2. Behavioural Finance
 Efficient Markets Hypothesis
 Integrating Psychology of Investment
 Simple rules of thumb
 Animal Spirits
 Major influence on modern finance and financial
regulation

3. Major Features
 Consumer and Investor Inertia
 Diversification and Decisions
 Financial Advisors and Face-To-Face Interaction
 Herding and Group Behaviour
 When less is more
 Implications for Policy and Risk Management

4. Inertia and Status Quo
 Status Quo Bias
 Very strong tendency to stick at initial options
presented
 Partly due to “laziness”, perception of default as
advice, anchoring effects
 Designers can use defaults for various purposes
 Large implications for marketing and regulation of
financial products

5. The power of suggestion
 Automatic enrollment is the most effective method to increase
participation in saving schemes (Madrian, 2012)
 Madrian & Shea (2001), Fortune 500 Health Care Company.
Male Aged 20-29 Income <$20k White Hispanic 75.1
80.0
100.0 100.0
82.7 100.0
100.0 88.2
85.7
80.0
79.5 80.0
80.0 80.0 60.0
60.0 60.0 60.0 60.0
42.3 42.7 40.0
%
%
%
%
%
40.0 40.0 40.0 40.0
25.3 19.0
20.0
20.0 20.0 20.0 12.5 20.0
0.0 0.0 0.0 0.0 0.0
WINDOW NEW WINDOW NEW WINDOW NEW WINDOW NEW WINDOW NEW
Overall
Female Aged 60-64 Income $80k+ Black 100.0
85.9
100.0 100.0 100.0 94.2 100.0
86.0 86.0 81.3 80.0
80.0 80.0 80.0 68.3 80.0
60.0 60.0
60.0 60.0 60.0 60.0
37.4
%
%
%
%
35.9
%
40.0 40.0 40.0
40.0 40.0
21.7
20.0 20.0 20.0 20.0 20.0
0.0 0.0 0.0 0.0 0.0
WINDOW NEW WINDOW NEW WINDOW NEW WINDOW NEW WINDOW NEW
5

6. The power of suggestion
 Participants stay with the default contribution rate.
 Madrian & Shea (2001)
WINDOW NEW
 Appropriate default saving
80% 76%
rates?
60%  Consistent with long-term
Fraction of Participants
investment goals?
40%
 Correct education
30%
message?
20% 16%
12% 12%
9%
11%  Matching contribution?
8% 8%
2% 2% 2%
4%
2% 1%
6% (Madrian, 2012)
0%
1-2% 3% 4-5% 6% 7-9% 10% 11-14% 15%
Contribution Rate
6

7. Herding Instincts
 Large literature on herding
 Peer effects and social norms
 Traders face powerful incentives not to be the only
ones wrong
 Regret aversion
 Using others as a source of information
 Self-fulfilling financial panics

9. Diversification and Decisions
 Home Bias in Investment Portfolios
 Reflects familiarity to some extent
 Large degree of underdiversification
 Very low rates of market participation
 Many single-asset households
 Preference for shares in own company
 Under-annuitisation

10. When less is more
 US 401k often has >15 million options
 Choice paralysis
 Simplification
 Quick Enrolment
 Framing of choice more important than number of
choices
 Differs according to financial capability

11. Simplifying choices to promote participation
 Quick Enrolment - Choi, Laibson and Madrian (2006)
 Key Features
 Low-cost manipulation
 Designed to simplify the 401(k) enrollment process. Employees
are given the option to make an election to enroll in their 401(k)
plan at a pre-selected contribution rate and asset allocation.
mechanism
 Simplifies the savings plan decision process.
 Key Results
 Quick Enrollment™ tripled 401(k) participation rates among new
employees three months after hire.
 When Quick Enrollment™ was offered to previously hired non-
participating employees at two firms, participation increased by
10 to 20 percentage points among those employees affected.

12. Financial advisors
 People do not tend to read small print
 Trust in the person they are speaking to a
fundamental driver of behaviour
 DG Sanco retail investor study
 Development of trust relationships online
 Important ethical and business implications

13. Main Implications
 Age of Rational-Man finance is over
 Assumptions of full rationality insufficient for risk
management in private and public institutions
 Understand investor/consumer decisions in greater
detail
 Role of default options in shaping behaviour
 Role of complexity in shaping behaviour

14. Managing Animal Spirits
 “To understand how economies work and how we
can manage them and prosper, we must pay
attention to the thought patterns that animate
people’s feelings and ideas, their animal spirits”.
We will never really understand important economic
events unless we confront the fact that their causes
are largely mental in nature”

16. Main Implications
 Understanding determinants of trust in financial
institutions
 Nudging individual behaviour
 Promoting active and more rational consumer
choices
 Avoiding mis-selling
 Building confidence and robustness in financial
systems
 Building institutions that allow innovation but have
more safety valves

18. Resources
 Brookings Institute Book on BE and Policy
http://www.brookings.edu/press/Books/2011/policyandch
oice.aspx
 Consumer Empowerment DG Sanco
http://ec.europa.eu/consumers/consumer_empowerment
/index_en.htm
 Behavioural Insights Team Cabinet Office
http://liamdelaneyecon.blogspot.com/2011/06/cabinet-
office-consumer-empowerment.html