Reading 11: Investment Decision Making in Defined Contribut Investment, holding, excess, factors

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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 c: Discuss the factors that may contribute to DC plan participants holding "excess" amounts of their own companys stock in their plan.

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Many defined contribution plan participants tend to hold a large amount of assets in company stock relative to other asset classes. Which of the following characteristics of a DC plan participants portfolio best reflects the reason behind this tendency?

A) Status quo bias.

B) Endorsement effect.

C) 1/n diversification heuristics.

D) Purely selfish investment motives.

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Answer and Explanation

DC participants tend to hold excess stock of the company they work for due to familiarity and a perceived endorsement by management. The endorsement effect refers to the misconception that by offering an investment as an alternative, the sponsor is implicitly endorsing it as a good investment. Note that the status quo bias refers to a lack of action on the part of the participant, while 1/n diversification heuristics refers to dividing funds equally over all investment options (not putting a disproportionate amount relative to other assets). Note that putting too much in company stock would be an example of an investor being boundedly selfish in that there does not seem to be a determination if the investment would be in the investors best interests.

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Leonard Busch is a employee of Matrix Technologies, and a participant in the Matrix Technologies defined contribution plan. The assets in the plan are the only investments he owns. Buschs investment allocation is shown below.

Allocation	Investment Option
20%	Yukon Large Cap Growth Fund
40%	Matrix Technologies Company Stock
15%	Yukon Intermediate Bond Fund
10%	Yukon Money Market Fund
15%	Yukon International Stock Fund

Which of the following factors is most likely to drive Buschs investment allocation?

A) Status quo bias.

B) 1/n diversification heuristics.

C) Familiarity.

D) Involuntary lethargy.

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Answer and Explanation

Looking at Buschs allocation, he obviously has a disproportionate amount of Matrix Technologies company stock. DC participants tend to hold excess stock of the company they work for due to familiarity and a perceived endorsement by management. Familiarity refers to investors selecting stocks with which they are comfortable with or have a proximity to. If company stock is offered as an investment option in a defined contribution plan, participants may feel a sense of control or allegiance to the firm and hold more company stock than is sensible, which is an effect of familiarity. Note that Buschs assets are not equally divided among investment options, which means the 1/n diversification heuristic would not seem to apply. Status quo bias or involuntary lethargy are clearly not the best answers given the weight in company stock.

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Kelly Lieb and Don Carsner are discussing their investments in the Shrader Tire 401(k) defined contribution plan. Lieb and Carsner make the following statements in their conversation:

Lieb:	Most of the money I have invested in our 401(k) plan is in Shrader Tire stock. Management would not include it as an option if it were not a good investment.
Carsner:	I allocate most of my money to Shrader Tire Company stock as well. I dont know anything about the other investment options, and I want to be loyal to the company.

Which of the following factors behind holding company stock best reflects Liebs comment and Carsners comment respectively?

Lieb's Comment

Carsner's Comment

A) Endorsement effect Endorsement effect

B) Endorsement effect Familiarity bias

C) Familiarity bias Familiarity bias

D) Familiarity bias Endorsement effect

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Answer and Explanation

Even without direct encouragement by the plan sponsor, employees tend to invest more in their companys stock that would be warranted from a diversification standpoint. Liebs and Carsners comments are reflective of the two primary factors that contribute to DC plan participants holding company stock: the endorsement effect and familiarity bias. Liebs comment reflects the endorsement effect which refers to the misconception that by offering an investment as an alternative, the sponsor is implicitly endorsing it as a good investment. Carsners comment is reflective of familiarity bias, which refers to investors selecting stocks with which they are comfortable with or have a proximity to. If company stock is offered as an investment option in a defined contribution plan, participants may feel a sense of control or allegiance to the firm and hold more company stock than is sensible, which is an effect of familiarity.

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Leonard Busch is a participant in the Matrix Technologies defined contribution plan. The assets in the plan are the only investments he owns. Buschs investment allocation is shown below.

Allocation	Investment Option
20%	Yukon Large Cap Growth Fund
40%	Matrix Technologies Company Stock
15%	Yukon Intermediate Bond Fund
10%	Yukon Money Market Fund
15%	Yukon International Stock Fund

Which of the following best describes fiduciary position of Matrix Technologies as it relates to ERISA requirements and Buschs allocation? Matrix Technologies is:

A) not in violation of ERISA requirements because the decision to invest a large percentage of funds in company stock is up to the participant.

B) in violation of ERISA requirements because company stock is not permitted as an option in a defined contribution plan.

C) in violation of ERISA requirements by allowing Busch to hold more than 10% of his plan assets in company stock.

D) only in violation if the employer forces Busch to invest any funds in company stock.

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Answer and Explanation

Looking at Buschs allocation, he obviously has a disproportionate amount of Matrix Technologies company stock. In 1974, U.S. Congress enacted a law (ERISA) that prohibits investment of more than 10 percent of defined benefit plan assets in company stock, but no such law applies to defined contribution plans. The only related provision states that employers cannot force participants to invest more than 10 percent in company stock. This means that employers could force employees to hold some percentage in company stock (many companies that match employee contributions will force the employee to hold those matching contributions in company stock). There is no provision that prohibits the employee from investing any amount they want in company stock; therefore, Matrix Technologies is not in violation of ERISA requirements.

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