The complex set of decisions employees currently face could be characterized as the do-it-yourself approach. The do-it-yourself approach makes the implicit assumption that individuals have a welldefined set of preferences. Put differently, we assume individuals know what they like and what they dislike. And, with sufficient information and guidance, individuals should be able to select a portfolio that fits their risk preferences. This assumption is open to challenge.
One example of confused preferences is provided by a 2003 study by Ariely et al. Subjects in the study were shown a bottle of wine and asked whether or not they would be willing to purchase the wine for a dollar amount equal to the last two digits of their Social Security Number (SSN). Next, subjects were asked to indicate the maximum amount they would be willing to pay for the wine.
Economic theory suggests that ones SSN should have nothing to do with ones preferences for cost of a bottle of wine. However, Figure 1 shows a strong correlation between SSN and the amount a subject was willing to pay for the wine. Those with the highest SSN were willing to pay three times more for the same bottle of wine than those with the lowest SSN. These results suggest that consumers often have confused preferences.
A recent study by Carranza et al (2006) suggests that individuals are also confused about their risk preferences. The researchers first asked subjects to indicate which political party they favour. Then, they presented subjects with four different investment funds, which were labelled conservative, moderately conservative, moderately risk-tolerant and risk-tolerant. The researchers hypothesized that making Republicans aware of their political identity would increase the attractiveness of the conservative funds.
The results in figure 2 confirm that Republicans and Democrats are as likely to select the conservative funds, unless their political identity is identified up front. When subjects were first asked for their political identity, 95% of Republicans picked the conservative funds and just 47% of Democrats selected the conservative funds.
In summary, consumers and individual investors do not seem to have well-defined preferences. Their choices are often influenced by factors that are totally irrelevant. These results raise important questions for plan sponsors and their advisors about the do-it-yourself approach. Is there much value in having participants build their own portfolios? Should we consider defaulting employees into a welldiversified portfolio?
Jo Cann, Marketing Director