Reading 11: Investment Decision Making in Defined Contribut profile, investment, 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 b: Evaluate the impacts of status quo bias, myopic loss aversion, 1/n diversification, and the endorsement effect on DC plan participants' investment decisions and the risk profile of their investment plans.

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Principle Business Enterprises (PBE) offers a 401(k) defined contribution plan for its participants. Mark Goetz, director of human resources for PBE is constantly looking for ways to improve the plan. Recently, PBE added the Republic Small Cap Value Fund and the Republic Emerging Market Funds to its line-up, bringing the number of investment options in the plan up to 14. Sherry Bailey and Yumin Li are both participants in the plan. Over lunch, Bailey and Li discuss the 401(k) plan.

Bailey states, I am excited about the new investment options in the plan. I think I am going to reallocate my 401(k) dollars between those two new funds. Since they were just added to the plan, they have to be good.

Li states, With 14 fund choices, Im not sure how to allocate my funds. I think I am going to leave my allocation where it is.

Which of the following characteristics of a DC plan participants portfolio is most reflective of Baileys comment and Lis comment respectively?

Bailey's Comment

Li's Comment

A) Status quo bias Status quo bias

B) Endorsement effect Status quo bias

C) Cognitive dissonance Cognitive dissonance

D) 1/n diversification heuristics Endorsement effect

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Answer and Explanation

Baileys comment is reflective of the endorsement effect, which refers to the misconception by plan participants that by providing a list of investment options, the sponsor is endorsing them as good investments. The endorsement effect is particularly prevalent if the sponsor adds new investment options. Lis comment is reflective of the status quo bias, which refers to a participants tendency to make an original allocation and not change it. Often times, a participant can be overwhelmed by the number of available investment options, which leads to the status quo bias. Note that 1/n diversification heuristics refers to an allocation being divided equally among the number of fund options, while cognitive dissonance refers to a persons actions differing from a persons beliefs.

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Typical individual investors tend not to understand the effects of correlation on their portfolio. Which of the following characteristics of a DC plan participants portfolio best reflects the attempt to derive benefits from the effects of correlation even though the participant does not understand those effects?

A) Status quo bias.

B) 1/n diversification heuristics.

C) Endorsement effect.

D) Familiarity.

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Answer and Explanation

Feeling that they should spread out their risk, but not knowing how leads to the 1/n diversification heuristic. Often times, participants will only have a rough understanding of the effects of correlation and diversification and will simply divide their assets equally over the investment options in the plan in an attempt diversify their portfolio.

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Steve Perlewitz, a retirement plan specialist for Mercantile Asset Advisors (MAA), is discussing the behavioral characteristics of individual investors in defined contribution retirement plans in an effort to educate MAAs sales team as they sell MAAs services. In his presentation, Perlewitz makes the following comments:

Comment 1:	An investor whose decisions are impacted by mental accounting are likely to hold on to losing investments too long, and sell winning investments too soon.
Comment 2:	Since mental accounting tends to guide investors toward more conservative asset classes, the portfolio of an investor impacted by mental accounting will tend to be more conservative than that of an investor who is not, assuming similar return objectives.
Comment 3:	The 1/n diversification methodology used by many DC plan participants is an example of nave diversification.
Comment 4:	If a defined contribution plan investor has an appropriate allocation in their retirement plan, the same allocation should also apply to their other investment accounts.

After listening to Perlewitzs presentation, sales team leader Vicki Bruning would be CORRECT to agree with:

A) Comments 2 and 3 only.

B) Comments 1, 2, and 4 only.

C) Comment 3 only.

D) Comments 2 and 4 only.

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Answer and Explanation

Perlewitz is only correct with respect to Comment 3. With 1/n diversification, where a DC plan participant divides his investment dollars equally across available investment options, diversification is by chance only and is not part of a total portfolio perspective. Such a diversification methodology is reflective of nave diversification. The other comments are incorrect. An investor whose decisions are impacted by mental accounting will look at investments as separate, focusing on the risk of investments in isolation. This means that the investor dismisses the effects of correlation, thus leading to more risky portfolios than an investor who does consider correlation. Note that the disposition effect refers to holding on to losing investments too long and selling winners too soon. Finally, diversification from an efficient perspective may allocate investments in tax-deferred accounts (like a retirement plan) differently than investments in taxable accounts, while still focusing on the investors allocation as a whole.

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