Reading 11: Investment Decision Making in Defined Contribut Investment, knowledge, investment, 2008

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CFA Institute Area 3-5, 7, 12, 14-18: Portfolio Management
Session 3: Behavioral Finance
Reading 11: Investment Decision Making in Defined Contribution Pension Plans
LOS a: Explain how limited participant knowledge and bounds to rationality, self-control, and self-interest may lead DC plan participants to construct inefficient investment portfolios.

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Amy Mudd was recently hired by Contis Capital Management as an education consultant for company defined contribution plans. Mudds role at the firm will be developing educational content and delivering that content to company employees to help them learn about their retirement plan. Jim Contis, the owner of the firm specializes in investment management, but makes the following statements to Mudd as she starts her new job:

Statement 1:	Individuals in defined contribution retirement plans need to be educated about the concepts of risk and return, but once they understand investing, individuals tend to make investment decisions that are in their own best interests.
Statement 2:	Once an individual investor in a defined contribution plan has attained a basic knowledge about investment concepts, they typically follow through on monitoring and making adjustments to their retirement plan.

With regard to Contis statements, Mudd should:

A) disagree with Statements 1 and 2.

B) agree with Statement 1, but disagree with Statement 2.

C) disagree with Statement 1, but agree with Statement 2.

D) agree with both statements.

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Answer and Explanation

Mudd should disagree with both statements. Individual investors do not always exhibit purely selfish investment motives. A term you may see on the exam is boundedly selfish, meaning individuals do not always make decisions that are in their own best interest. One of the factors that limits the ability of defined contribution plan investors is simply lethargy. Even when individuals understand investing concepts, they tend to lack the self-discipline to follow through or monitor their investment plans.

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Dina Wilder is an institutional portfolio manager with DiCenzo Retirement Plan Advisors, a firm specializing in the administration of company defined contribution retirement plans. Lou LaJoe, Wilders supervisor, has asked her to compile a list of characteristics of defined contribution plan participants that limit their ability to successfully manage their investments. When making her list, Wilder wrote down the following characteristics.

Characteristic 1:	Individuals do not understand the risk and return characteristics between different asset classes.
Characteristic 2:	DC plan investors tend to think about the investment returns and dollar amount they will need when planning for retirement, but do not know how to calculate reasonable estimates.
Characteristic 3:	Many investors simply do not care about learning about investments in order to manage their retirement plan.

LaJoe reviews Wilders list. Which of the characteristics she describes are CORRECT?

A) All three of the characteristics are correct.

B) Characteristics 2 and 3 only.

C) Characteristics 1 and 2 only.

D) Characteristics 1 and 3 only.

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Answer and Explanation

Characteristics 1 and 3 are definitely reflective of participants in defined contribution plans, but Characteristic 2 is not. DC plan investors tend to think about retirement itself (spending days on the beach) but do not think at all about dollar amounts and return requirements. This is a significant factor that limits the ability of defined contribution plan investors to successfully manage their investments.

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Karey Kruer has been tasked with educating the employees of Midwest Microwave about their new defined contribution retirement plan. If the employees at Midwest Microwave are similar to typical defined contribution (DC) plan employees, which of the following is Kruer most likely to encounter? Plan participants:

A) understand that different assets move differently and that combining assets will reduce the risk in their portfolio.

B) understand the difference between growth and value styles of investing, but not how to use them in a portfolio setting.

C) who do not understand investing concepts will seek help in order to help them implement and manage their retirement plan portfolio.

D) think about retirement itself and not the dollar amount they will need to get to retirement.

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Answer and Explanation

One of the factors that may limit the ability of DC plan participants to successfully manage their investments is the fact that participants tend to think about retirement itself (spending days on the beach) but do think at all about dollar amounts and return requirements that they will need to get to retirement. The other answer choices listed are not reflective of typical individual investors in retirement plans. Perhaps the biggest impediment for DC plan participants is lack of understanding of investment concepts. Most do not understand the concept of correlation and how to properly diversify a portfolio, nor do they understand the concepts of investing styles such as growth or value investing. Plan participants are also characterized by lethargy if they view investing as too complex to understand, they are most likely to throw some investments together and let it sit if they do anything at all. Even if participants do understand investing concepts, many lack the self-discipline to follow through or monitor their plans.

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