Project 7Explaining Household Portfolio Choice in

Saving for Retirement:Neoclassical and Behavioral Influences

Tyler Shumway

Miles Kimball

Matthew Shapiro

(Claudia Sahm)

May 13, 2004

Specific Aims

• Explain household portfolio choice with– Neoclassical variables – demographics, risk

tolerance, human capital, health, wealth, income, a fixed cost

– Behavioral variables – first order risk aversion, mental accounting, sophistication, folk theories

• Use existing HRS data and new questions

• Submit as an R0-1 on June 1?

Significance

• There is a lot of unexplained heterogeneity in portfolio choice

– Participation in stock market

– Asset allocation (stocks vs. bonds)

– Diversification of portfolio

• With 401(k) plans and privatization of social security, portfolio choice is important

Behavioral vs. Neoclassical

• Two good reasons to care about neoclassical vs. behavioral choices

– Potential welfare improvement

– Improved economic modeling

• To decompose choices, we need to be able to control for both simultaneously

Past Research

• Barsky, Juster, Kimball and Shapiro (1997) explain households’ fraction of wealth in stocks, get an R2 of 6%

• Kezdi and Willis explain a little more with expectations, but heterogeneity remains

• Lots of behavioral research in proposal

Methods

• Six subprojects:

– Stationarity in Preference Measures

– Risk Tolerance and Behavior

– Integration of Human Capital

– First Order Risk Aversion

– Diversification and Sophistication

– Folk Theories

Stationarity

• Preferences in neoclassical theory are stable• Measured preferences vary quite a bit• We plan to ask whether preference variation

is systematic– Status-quo bias – new versus old question– Market returns– Sentiment variables– Expectations– Wealth

Risk Tolerance and Behavior

• We propose a new way to correct for measurement error in imputed tolerance

• If tolerance is i, stock share is Si and other covariates are Zi, we want to regress

Si = i + Z Zi + vi

• The problem- we cannot observe tolerance, just risk category ci.

Risk Tolerance and Behavior

• Our measurement error correction adjusts the moments of imputed tolerance

• We can show thatVar[i] = Var[E(i|ci)]

Cov[Si, i] = Cov[Si, E(i|ci)]

Cov[Zi, i] = Cov[Zi, E(i|ci)]

• Where = Var[i] /Var[E(i|ci)]

Human Capital

• People should integrate their human capital into their portfolio decisions– Value– Risk – volatility and correlation

• We will examine how far from optimal choices appear to be

• There is a serious endogeneity problem here – new measurement error correction

First Order Risk Aversion

• In 2000 HRS module, “small risk” question

• People that are as averse to small risk as they are to large risk display FORA

• We will estimate prevalence of FORA

• Look for evidence that FORA affects portfolio choice – sample size issue

Diversification and Sophistication

• It’s possible that people are rationally ignorant

• People clearly do not diversify enough

• Measure the sophistication of investors

• Correlate sophistication with diversification

• Approximate implied cost of sophistication

Sophistication Questions

• How financially sophisticated are you?• How much formal financial training have

you undertaken?• How often do you watch financial news

programs?• How often do you check the value of your

portfolio holdings?• When interest rates go up, do bond prices

go up, stay the same, or go down?

Sophistication Questions• Do you agree with, disagree with, or have no

opinion about the following statements: – It's better to get 1000 dollars today than 1000

dollars next year.– It's safer to invest your money in stocks than to put

your money into a bank savings account.– Most mutual funds hold just one or two stocks.– It's impossible to lose money investing in

government bonds.– If you identify a solid, well-run company, you can't

go wrong buying the company's stock, no matter how much you pay for it.

Sophistication Questions

• Which of the following proverbs is most important for reducing the risk of your investments:– The early bird gets the worm– Waste not, want not– Go with proven performers– Don't keep all of your eggs in one basket– Stick with what you know

Sophistication Questions

• Which of the following concepts is most important for reducing the risk of your investments:– Diversification – Intermediation– Securitization – Privatization – Identification

Sophistication Questions

• What investment portfolio would you recommend to someone that is extremely sensitive to risk:– A long-term corporate bond– A utility company stock– Five utility company stocks– Five stocks from different industries and three

different bonds– Stock from a company they are familiar with

Folk Theories

• Finally, we want to allow for some folk theories to drive behavior

• Folk theories come from undergraduate survey, previous literature

• Five ideas: markets not very efficient (overconfidence), mental accounting, horizons matter, sentiment is good, brokers are never trustworthy.

Folk Theory Questions

• If the market has gone up over the past year, is it a good time to buy stocks, sell stocks, or make no change to your portfolio?

• If a stock broker or financial analyst recommends a stock, is that stock likely to perform well, perform poorly, or match the market rate of return?

• In making your financial decisions, are you influenced more by your gut instincts or some mathematical analysis?

Folk Theory Questions

• Do you agree with, disagree with, or have no opinion about the following statements: – By doing a little research, it is easy to find

undervalued stocks.– Stock brokers and financial analysts generally

provide valuable services to their clients.– Financial services professionals are usually

as trustworthy as other professionals like doctors and lawyers.

Folk Theory Questions

• Do you agree with, disagree with, or have no opinion about the following statements: – It is usually a good idea for ordinary people to

hold stocks.– You should be prepared to lose any money that

you put into stocks.– Stock market insiders are the only investors that

ever make any money in the market.– You can usually tell when the market is going to

go up and when it is going to go down.

Folk Theory Questions

• Do you primarily make financial decisions by yourself or do you consult with someone else?

• If you consult with someone else, is that person: – a close family friend?– a relative?– a financial professional?– more trustworthy than most people?

Folk Theory Questions

• If you suddenly need to make a large purchase, would you be more inclined to – borrow against the value of your investments?– sell your riskier investments?– sell your safer investments?– sell some of all of your investments?

Folk Theory Questions

• If you suddenly realized that you are going to need your investment funds earlier than you had anticipated, would you increase your stock holdings, decrease your stock holdings, or leave your holdings the same?

• If you had a large amount of money to invest for a long period of time, would you put all the money in stocks at once or slowly buy stocks over several years?

Undergraduate Responses

I. Valid under EMT A. risk/return tradeoff---adjust for risk tolerance B. diversification C. taxes D. fees E. effort F. full range of securities 1. international 2. human capital (age) 3. house

Undergraduate Responses

I. Valid Under EMT G. Hedging 1. human capital 2. house 3. interest rate riskII. Can Be Valid Under Noise Traders or Imperfect

Markets A. Finding underpriced stocks (Ben Graham)

Undergraduate ResponsesII. Can Be Valid Under Noise Traders or Imperfect Markets B. Market timing 1. contrarian 2. momentum 3. forecast macro fundamentals a. interest rates b. exchange rates c. other business cycle variables C. Income versus growth stocks D. Mean-reverting market

Undergraduate ResponsesIII. First Order Risk Aversion A. Time Horizon (Benartzi-Thaler)IV. Imperfect Information A. Market is risky--stay out or do only a little.V. Mental Accounts A. Liquid wealth B. Disposable wealth C. Case by case D. Dollar cost averaging E. Tailor to goals F. Long run/short-run

Undergraduate Responses

VI. Hocus Pocus or Otherwise Wrong-Headed A. Technical analysis B. More wealth--> do more transactions C. Buy stock in well-run companies or companies

with high profits D. Sectoral, e.g., high tech. E. Misunderstanding of diversification 1. several different mutual funds 2. something risky + something safe 3. only need diversification if one has high

risk aversion

Your Suggestions

• Please suggest folk theories or other ideas we have overlooked

• Please help us come up with better questions

• Please help us make our proposal attractive – help us package it well

• Thanks for the all the help you can give us