OPINION
2019 Oct/22
Protecting Retail Investors based on Behavioral Economics
Oct. 22, 2019
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- Summary
- Investors need to freely choose an investment product under the self-responsibility principle and bear losses and profits arising from their own investment. This premises that an informed investment decision has been made based on analyses of an investor who is able and willing to meticulously collect information and think it through. From the behavioral economics perspective, however, this is just an ideal situation that is hard to come across. In reality, a great number of investors don’t think much about the product composition, fees, risks, expected returns, their own asset portfolio, etc. before making investment decisions. Rather, they just buy what their bank recommends. When they directly select their own product, they often fall into the error, believing that past performance guarantees future returns. Behavioral economics admits human irrationality and incompleteness, and points to a practical pitfall where too strict application of the self-responsibility principle might jeopardize investor protection. This article tries to deepen understanding about the characteristics of retail investors based on behavioral economics, and explore ways for investor protection that would be effective in terms of information delivery and financial education. Going forward, Korea’s legislation of the financial consumer law is expected to lay down the fundamental framework for financial consumer protection. In line with the legislative effort, I expect more heated discussion on effective ways to protect retail investors via more attention and further research on investors’ behavioral bias.
Does whether a fund presents its costs and charges in a percentage or amount affect an investor’s investment decision? Classical theory that assumes rational investors says no because although presented differently, the two are the same in substance. In reality, however, the result proves otherwise. Investors make better investment decisions when charges are presented in amounts, not in percentages.
Not only in controlled experiments but also in our everyday life, we often see retail investors acting rather abnormally. A large number of investors just purchase what their bank recommends without thorough analyses on the product composition, charges, risks and expected returns, their overall asset portfolios, etc. before making investment decisions. Even when they try to select products by themselves, they often mistakenly regard past performance as an indicator for future performance. Indeed, financial consumers make many irrational decisions that couldn’t be explained by rationality of classical economics. Behavioral economics begins with recognizing such human incompleteness and irrationality as universal. It assesses market participants’ erroneous behavior, seeking to find ways to lead them to a better choice.
Behavioral economics approach is useful and efficient in many ways. First of all, there’re many aspects that could be hardly dealt with by regulation. And behavioral economics analyses and responses complement the very aspects. Even a perfect regulatory framework for consumer protection, if that exists anywhere, may not be able to provide adequate protection due to human irrationality and behavioral bias. If new regulation fails to consider investor behavior and bias, this could lead to unexpected outcomes or weaken intended regulatory effects. Furthermore, instead of directly regulating the market and the participants by restricting certain behavior, such as limiting the access of certain investor classes to complex products or directly regulating product distributors, behavioral analyses could help encourage consumers to shift towards a desirable direction. This could expand consumer choices and increase utilities across the board. In this regard, financial authorities in other countries as well as international organizations such as the International Organization of Securities and OECD have underlined the importance of behavioral economics and reflected them in policies since the early and mid-2010s. This article tries to deepen understanding about retail investors based on behavioral economics, and then explore ways to protect financial consumers that are effective in terms of financial education.
Behavioral bias of financial consumers
A heuristic means a sort of mental shortcut via which we make an economic decision. Heuristic-based decisions often involve systematic errors or bias, different form rational decision making in classical economics.
Such abnormalities, although viewed as irrational from the perspective of classical economics, show some consistency and patterns that could be classified into certain patterns. Roughly, there are two cases behind irrational behavior. First, errors could occur during information processing. Investors don’t always process given information in a right way, which could give rise to cognitive errors. Second, even if information is interpreted and processed well, investors’ belief or preference could result in behavioral bias.
A classic example of the error arising from misinterpretation is over-confidence, where one’s capabilities or intellectual abilities are overestimated than they actually are. Following the false belief for higher returns, investors could behave intuitively, instead of processing information rationally. Overly confident about their investment abilities, investors often buy and sell financial vehicles repeatedly during a short period of time, which worsens their investment returns. Another behavior worth noting is conservative bias. When investors receive a new piece of information, it usually takes a substantial amount of time for such information to trigger an actual change in their belief or behavior. This could explain the momentum effect where stock market returns continue to rise or fall. Lastly, representativeness bias occurs when investors regard information from a sample as a general feature representing the overall population. This error could result in overreaction, contrary to underreaction arising from conservatism.
On the other hand, there are many irrational biases when investor preferences are affected by emotional and psychological states. One of the common examples is prospect theory where investor utilities are determined by not the level of wealth, but the changes in wealth. Also notable in this theory is the difference in investor attitude towards losses and profits. Based on this theory, investors who are often reluctant to admit their investment loss don’t cut their loss (loss aversion). Or, they hold the losing stock while selling the winning stock without any logical grounds (disposition effect). Another phenomenon, mental accounting, refers to that the effect of one event could differ depending on how the event is presented. In decision-making, investors tend to separate each of their investments to put it into different psychological accounts without a holistic view. By treating each of their investments separately, they don’t consider interaction among them. This leads to a wide range of behavior that can’t be properly explained by classical economics. For example, investors may make different choices about the same financial vehicle if its details are presented differently (framing effect). Also, when the majority of investors make investment decisions shifting towards a certain direction, other investors often unconditionally follow that direction (herd behavior).
How information is presented
What’s important is how we help investors shift away from cognitive errors and behavioral bias towards rationale and informed investment decisions. First of all, we need to provide investors with grounds based on which they make informed decisions. But classical economics and behavioral economics have different views on information. Classical economics assumes that financial consumers with necessary information make decisions for maximizing their asset value or utilities after thorough cost-benefit and risk analyses. Under such a perspective, what matters to a rational decision-making environment is whether sufficient information is publicly available for financial consumers to access.
On the contrary, behavioral economics believes that sufficient information doesn’t necessarily lead to right outcomes due to a few potential patterns of investor behavior. First, when investors are given adequate information, their time and attention for processing such information can’t be evenly spread throughout every piece of information. In practice, their attention is limited within a limited timeframe. For example, although they find something missing in a public disclosure, they tend to make decisions based on given information only, instead of making more effort to fill in the gap. Second, making an investment decision is a complex, difficult process in nature. It requires multiple arduous tasks, such as an analysis on expected returns and risks, a review on the complex fee structure, and a choice for the best product among many similarly-structured products. Ideally, investors are expected to reach an optimal outcome after sophisticated analyses where they’ve exerted their best capabilities for rational decision-making. Instead, they often just want to get away from their trouble by simply putting off their decision, or by turning to a heuristic approach capitalizing on their experiences or intuition. Third, when objective information filters through investors’ heuristics or bias, distortions occur, for example, a misjudgment on the value of specific information, or an irrational decision due to psychological effects. More specifically, investors may fail to realize that the small fee difference today could result in the huge difference in investment returns due to the miracle of compounding. Or, they may mistakenly put past performance ahead of others such as fees or future returns when choosing a fund product.1)
Fully recognizing such issues, behavioral economics shifts its attention from the quantity of information towards the disclosure design, a format and method via which information is disseminated to financial consumers.2) For better delivery of information, important information should be placed where investors are expected to focus their attention. Pouring out as much information as possible regardless of its importance to investors could do more harm than good because it could overwhelm the investors, possibly causing negative outcomes. Hence, material information should be placed in a salient way that could induce investors to intuitively grasp it. Second, disclosures should be written in plain language. The case of how fund charges are presented mentioned above suggests that plain language could help retail investors comprehend better and thus make informed decisions. Third, descriptions in disclosures should be complemented by graphical elements such as figures, tables, and other graphical features to enhance investor understanding. For example, a graphical figure that displays a fund’s risk level, return, and fee could help investors easily compare key features across fund products. In particular, it would be of great help for investors to better understand stocks if a graphical diagram is used to put together stock profitability and risks that are inseparable due to their inherent nature.
Efficiency of financial literacy and education3)
Financial education means a lot to retail investors. It helps financial consumers, retail investors in this context, enhance their confidence and understanding of the market, and ultimately reach informed investment decisions based on given information. However, the investor class, whose financial education is regarded as particularly important from the perspective of behavioral economics, tend to be more uninterested and passive about financial education, and thus lack financial literacy. In general, an overwhelming amount of information could cause cognitive overload and make investors try to avoid the choice itself. Also, their status quo bias predisposes them to stay with their current choice or postpone the decision even if there’s a new piece of information. This is why more behavioral approach and analyses are necessary for retail investors.
From the perspective of behavioral economics, the first thing considered before implementing financial education is debiasing, which either eliminates or reduces bias, the direct cause of irrational choices. From a decision maker’s standpoint, debiasing is again divided into two aspects, one that reduces behavioral bias, and the other that changes the decision-making environment.4)
First of all, education is expected to reduce irrational behavioral bias involved in the decision-making process of retail investors who are the decision maker. Simply put, teaching investors the concept and importance of portfolio diversification and quantitative methods analyzing expected returns against risks could highly likely make their decisions more rational than before. The effect will be greater if a customized training program is provided based on a thorough review on investors’ cognitive limitations. Also, education about different points in time could improve overconfidence or confirmation bias. This is possible by inducing investors to predict and analyze the causes behind any success or failure not only at the present, but also from the future points in time. An experiment of such education is found effective among not only retail investors but also institutional investors. Furthermore, simply placing an explicit warning about overconfidence is reported to effectively reduce the bias of professional investors.5)
Second, it’s possible to change the environment to induce better analyses and informed choices. The simplest way is to offer explicit economic or non-economic incentives. Offering monetary benefits such as subsidies, fines, and bonuses for a change in behavior is a traditional type of incentives. Non-economic incentives could be that regulators clarify self-responsibility of any issue regarding behavior, provide new information, or state new social norms, etc.
Instead of such explicit incentives or regulatory measures, a more subtle and sophisticated technique, namely the choice architecture, could be used for inducing informed choices. A case in point is found in the default savings rate and asset allocation requirement in the choice of retirement pension plans. With the adoption of auto enrollment plans, participation in 401(k), the US retirement pension scheme, increased dramatically.
Effectively levering investors’ status quo bias, referring to a tendency to remain unchanged instead of being proactive, US regulators presented a framework where the default offers a right outcome.6) Another example is an experiment to raise fund investors’ sensitivity to fees. The experiment put a simple warning aiming to improve investor behavior that favors funds with great past performance over low-fee funds. The result shows that investor choices improve simply by warning investors on the fact that low-fee funds tend to have higher returns although most investors rely on past performance.7)
Implications
Investors should select investment products based on their free will, and bear the losses and profits resulting from their decisions. In other words, they should meticulously collet information they need for investment, and think through product details, profits and losses, investment risks, the fee structure, etc. All of the consequences of investment fall on the investors themselves. This is so-called self-responsibility, a widely-held principle in the financial market.
It’s not that behavioral economics tries to deny the self-responsibility principle. It just points to the practical limit where self-responsibility, if too strictly applied, could possibly jeopardize investor protection. As the financial industry becomes more sophisticated and financial products get more complex, there have been more and more cases reporting doubts about fully informed investment decisions based on understanding about product features and their relation with other products or overall economic conditions. Not only various external factors but also investors’ heuristics and biases inherent in human decision-making often drive investors to restrict and distort their own behavior.
In Korea, the financial consumer protection bill has been already proposed. If the bill finally becomes a law, this is expected to lay down a fundamental framework for protecting financial consumers. However, the characteristics in investor behavior mentioned above suggest that substantial improvement in consumer protection is a daunting task that can’t be easily realized by new regulations, tougher rules, and more information. What Korea needs in line with the legislative effort is continuous research interest in investors’ behavioral bias from which to draw out policy implications and to further enhance the efficiency of consumer protection.
Not only in controlled experiments but also in our everyday life, we often see retail investors acting rather abnormally. A large number of investors just purchase what their bank recommends without thorough analyses on the product composition, charges, risks and expected returns, their overall asset portfolios, etc. before making investment decisions. Even when they try to select products by themselves, they often mistakenly regard past performance as an indicator for future performance. Indeed, financial consumers make many irrational decisions that couldn’t be explained by rationality of classical economics. Behavioral economics begins with recognizing such human incompleteness and irrationality as universal. It assesses market participants’ erroneous behavior, seeking to find ways to lead them to a better choice.
Behavioral economics approach is useful and efficient in many ways. First of all, there’re many aspects that could be hardly dealt with by regulation. And behavioral economics analyses and responses complement the very aspects. Even a perfect regulatory framework for consumer protection, if that exists anywhere, may not be able to provide adequate protection due to human irrationality and behavioral bias. If new regulation fails to consider investor behavior and bias, this could lead to unexpected outcomes or weaken intended regulatory effects. Furthermore, instead of directly regulating the market and the participants by restricting certain behavior, such as limiting the access of certain investor classes to complex products or directly regulating product distributors, behavioral analyses could help encourage consumers to shift towards a desirable direction. This could expand consumer choices and increase utilities across the board. In this regard, financial authorities in other countries as well as international organizations such as the International Organization of Securities and OECD have underlined the importance of behavioral economics and reflected them in policies since the early and mid-2010s. This article tries to deepen understanding about retail investors based on behavioral economics, and then explore ways to protect financial consumers that are effective in terms of financial education.
Behavioral bias of financial consumers
A heuristic means a sort of mental shortcut via which we make an economic decision. Heuristic-based decisions often involve systematic errors or bias, different form rational decision making in classical economics.
Such abnormalities, although viewed as irrational from the perspective of classical economics, show some consistency and patterns that could be classified into certain patterns. Roughly, there are two cases behind irrational behavior. First, errors could occur during information processing. Investors don’t always process given information in a right way, which could give rise to cognitive errors. Second, even if information is interpreted and processed well, investors’ belief or preference could result in behavioral bias.
A classic example of the error arising from misinterpretation is over-confidence, where one’s capabilities or intellectual abilities are overestimated than they actually are. Following the false belief for higher returns, investors could behave intuitively, instead of processing information rationally. Overly confident about their investment abilities, investors often buy and sell financial vehicles repeatedly during a short period of time, which worsens their investment returns. Another behavior worth noting is conservative bias. When investors receive a new piece of information, it usually takes a substantial amount of time for such information to trigger an actual change in their belief or behavior. This could explain the momentum effect where stock market returns continue to rise or fall. Lastly, representativeness bias occurs when investors regard information from a sample as a general feature representing the overall population. This error could result in overreaction, contrary to underreaction arising from conservatism.
On the other hand, there are many irrational biases when investor preferences are affected by emotional and psychological states. One of the common examples is prospect theory where investor utilities are determined by not the level of wealth, but the changes in wealth. Also notable in this theory is the difference in investor attitude towards losses and profits. Based on this theory, investors who are often reluctant to admit their investment loss don’t cut their loss (loss aversion). Or, they hold the losing stock while selling the winning stock without any logical grounds (disposition effect). Another phenomenon, mental accounting, refers to that the effect of one event could differ depending on how the event is presented. In decision-making, investors tend to separate each of their investments to put it into different psychological accounts without a holistic view. By treating each of their investments separately, they don’t consider interaction among them. This leads to a wide range of behavior that can’t be properly explained by classical economics. For example, investors may make different choices about the same financial vehicle if its details are presented differently (framing effect). Also, when the majority of investors make investment decisions shifting towards a certain direction, other investors often unconditionally follow that direction (herd behavior).
How information is presented
What’s important is how we help investors shift away from cognitive errors and behavioral bias towards rationale and informed investment decisions. First of all, we need to provide investors with grounds based on which they make informed decisions. But classical economics and behavioral economics have different views on information. Classical economics assumes that financial consumers with necessary information make decisions for maximizing their asset value or utilities after thorough cost-benefit and risk analyses. Under such a perspective, what matters to a rational decision-making environment is whether sufficient information is publicly available for financial consumers to access.
On the contrary, behavioral economics believes that sufficient information doesn’t necessarily lead to right outcomes due to a few potential patterns of investor behavior. First, when investors are given adequate information, their time and attention for processing such information can’t be evenly spread throughout every piece of information. In practice, their attention is limited within a limited timeframe. For example, although they find something missing in a public disclosure, they tend to make decisions based on given information only, instead of making more effort to fill in the gap. Second, making an investment decision is a complex, difficult process in nature. It requires multiple arduous tasks, such as an analysis on expected returns and risks, a review on the complex fee structure, and a choice for the best product among many similarly-structured products. Ideally, investors are expected to reach an optimal outcome after sophisticated analyses where they’ve exerted their best capabilities for rational decision-making. Instead, they often just want to get away from their trouble by simply putting off their decision, or by turning to a heuristic approach capitalizing on their experiences or intuition. Third, when objective information filters through investors’ heuristics or bias, distortions occur, for example, a misjudgment on the value of specific information, or an irrational decision due to psychological effects. More specifically, investors may fail to realize that the small fee difference today could result in the huge difference in investment returns due to the miracle of compounding. Or, they may mistakenly put past performance ahead of others such as fees or future returns when choosing a fund product.1)
Fully recognizing such issues, behavioral economics shifts its attention from the quantity of information towards the disclosure design, a format and method via which information is disseminated to financial consumers.2) For better delivery of information, important information should be placed where investors are expected to focus their attention. Pouring out as much information as possible regardless of its importance to investors could do more harm than good because it could overwhelm the investors, possibly causing negative outcomes. Hence, material information should be placed in a salient way that could induce investors to intuitively grasp it. Second, disclosures should be written in plain language. The case of how fund charges are presented mentioned above suggests that plain language could help retail investors comprehend better and thus make informed decisions. Third, descriptions in disclosures should be complemented by graphical elements such as figures, tables, and other graphical features to enhance investor understanding. For example, a graphical figure that displays a fund’s risk level, return, and fee could help investors easily compare key features across fund products. In particular, it would be of great help for investors to better understand stocks if a graphical diagram is used to put together stock profitability and risks that are inseparable due to their inherent nature.
Efficiency of financial literacy and education3)
Financial education means a lot to retail investors. It helps financial consumers, retail investors in this context, enhance their confidence and understanding of the market, and ultimately reach informed investment decisions based on given information. However, the investor class, whose financial education is regarded as particularly important from the perspective of behavioral economics, tend to be more uninterested and passive about financial education, and thus lack financial literacy. In general, an overwhelming amount of information could cause cognitive overload and make investors try to avoid the choice itself. Also, their status quo bias predisposes them to stay with their current choice or postpone the decision even if there’s a new piece of information. This is why more behavioral approach and analyses are necessary for retail investors.
From the perspective of behavioral economics, the first thing considered before implementing financial education is debiasing, which either eliminates or reduces bias, the direct cause of irrational choices. From a decision maker’s standpoint, debiasing is again divided into two aspects, one that reduces behavioral bias, and the other that changes the decision-making environment.4)
First of all, education is expected to reduce irrational behavioral bias involved in the decision-making process of retail investors who are the decision maker. Simply put, teaching investors the concept and importance of portfolio diversification and quantitative methods analyzing expected returns against risks could highly likely make their decisions more rational than before. The effect will be greater if a customized training program is provided based on a thorough review on investors’ cognitive limitations. Also, education about different points in time could improve overconfidence or confirmation bias. This is possible by inducing investors to predict and analyze the causes behind any success or failure not only at the present, but also from the future points in time. An experiment of such education is found effective among not only retail investors but also institutional investors. Furthermore, simply placing an explicit warning about overconfidence is reported to effectively reduce the bias of professional investors.5)
Second, it’s possible to change the environment to induce better analyses and informed choices. The simplest way is to offer explicit economic or non-economic incentives. Offering monetary benefits such as subsidies, fines, and bonuses for a change in behavior is a traditional type of incentives. Non-economic incentives could be that regulators clarify self-responsibility of any issue regarding behavior, provide new information, or state new social norms, etc.
Instead of such explicit incentives or regulatory measures, a more subtle and sophisticated technique, namely the choice architecture, could be used for inducing informed choices. A case in point is found in the default savings rate and asset allocation requirement in the choice of retirement pension plans. With the adoption of auto enrollment plans, participation in 401(k), the US retirement pension scheme, increased dramatically.
Effectively levering investors’ status quo bias, referring to a tendency to remain unchanged instead of being proactive, US regulators presented a framework where the default offers a right outcome.6) Another example is an experiment to raise fund investors’ sensitivity to fees. The experiment put a simple warning aiming to improve investor behavior that favors funds with great past performance over low-fee funds. The result shows that investor choices improve simply by warning investors on the fact that low-fee funds tend to have higher returns although most investors rely on past performance.7)
Implications
Investors should select investment products based on their free will, and bear the losses and profits resulting from their decisions. In other words, they should meticulously collet information they need for investment, and think through product details, profits and losses, investment risks, the fee structure, etc. All of the consequences of investment fall on the investors themselves. This is so-called self-responsibility, a widely-held principle in the financial market.
It’s not that behavioral economics tries to deny the self-responsibility principle. It just points to the practical limit where self-responsibility, if too strictly applied, could possibly jeopardize investor protection. As the financial industry becomes more sophisticated and financial products get more complex, there have been more and more cases reporting doubts about fully informed investment decisions based on understanding about product features and their relation with other products or overall economic conditions. Not only various external factors but also investors’ heuristics and biases inherent in human decision-making often drive investors to restrict and distort their own behavior.
In Korea, the financial consumer protection bill has been already proposed. If the bill finally becomes a law, this is expected to lay down a fundamental framework for protecting financial consumers. However, the characteristics in investor behavior mentioned above suggest that substantial improvement in consumer protection is a daunting task that can’t be easily realized by new regulations, tougher rules, and more information. What Korea needs in line with the legislative effort is continuous research interest in investors’ behavioral bias from which to draw out policy implications and to further enhance the efficiency of consumer protection.
1) FCA, 2018, Now You See It: Drawing Attention to Charges in the Asset Management Industry.
2) IOSCO, 2019, The Application of Behavioural Insights to Retail Investor Protection.
Oxera, 2014, Review of Literature on Product Disclosure.
3) OECD, 2013, Improving Financial Education Effectiveness through Behavioural Economics.
4) Soll, J. B., Milkman, K. L., Payne, J. W., 2015, A user’s guide debiasing, The Wiley Blackwell Handbook of Judgment and Decision Making. Vol. II.
5) Kaustia, M., Perttula, M., 2012, Overconfidence and Debiasing in the Financial Industry, Review of Behavioral Finance, 4(1): 46-62.
6) Madrian, B. C., Shea, D. F., 2001, The power of suggestion: Inertia in 401(k) participation and savings behavior, The Quarterly Journal of Economics 116(4): 1149-1187.
7) Newall, P., Parker, K., 2018, Improved mutual fund investment choice architecture, Journal of Behavioural Finance, 20: 96-106.