The psychology of savings and investment

David Laibson interviewed by Romesh Vaitilingam, 02 January 2009

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<p class="MsoNormal"><o:p></o:p>Romesh Vaitilingam interviews David Laibson for Vox<o:p></o:p></p>
<p class="MsoNormal">November 2007<o:p></o:p></p>
<p class="MsoNormal"><o:p></o:p>Transcription of an VoxEU audio interview<o:p></o:p> []<o:p></o:p></p>
<p><strong>Romesh Vaitilingam:</strong> Welcome to Vox Talks, a series of audio interviews with leading economists from around the world. My name is Romesh Vaitilingam and today's interview is with Professor David Laibson from <st1:place w:st="on"><st1:placename w:st="on">Harvard</st1:placename> <st1:placetype w:st="on">University</st1:placetype></st1:place>. David and I met at the Center for Economic Performance at the London School of Economics in November, 2007, where he was delivering the Lionel Robbins lectures. The title of the lecture series was &rdquo;The Psychology of Savings and Investment&rdquo;. And I began by asking David why, as an economist, his main focus seemed to be on psychology. <o:p></o:p></p>
<p class="MsoNormal"><strong>David Laibson:</strong> Well, I am an economist, but I spend a lot of time thinking about the psychological factors that influence peoples' choices. And I&rsquo;m phrasing it &ldquo;The Psychology of Savings and Investment&rdquo; because I do want to contrast the psychological approach with the traditional, classical, economic approach. When I went to graduate school, we were taught that everyone was rational, that they optimized. And more recently, the view has developed that, while most of economic behaviour is pretty rational and pretty optimal, we do occasionally depart &hellip; and those departures can be studied, can be measured, can be formalized, can be modelled, and this lecture series is about those efforts to enrich our understanding of economic behaviour by adding the psychological components that, in essence, complete the picture. <o:p></o:p></p>
<p class="MsoNormal"><o:p>&nbsp;</o:p></p>
<p class="MsoNormal"><strong>Romesh</strong>: So really, this is a fairly recent innovation, to bring these sort of psychological understandings into economics. You said when you were in graduate school it was very much the rational, economic man, the way we understood peoples&rsquo; behaviour. This is fairly new stuff. <o:p></o:p></p>
<p class="MsoNormal"><o:p>&nbsp;</o:p></p>
<p class="MsoNormal"><strong>David:</strong> That's right. So, the big bang for this field came in 1979. That's when a very important paper about something called &ldquo;Prospect Theory&rdquo;, which was in essence a paper about how people think about risky outcomes, was written by Danny Kahnneman and Amos Tversky. And had Amos not died, they both would have been awarded a Nobel Prize. As it turns out, Danny received the Nobel Prize, I think in 2001. And that was in essence the start of this field. Before that, there was really nothing in the contemporary literature about psychology. But even though the field started then, it had very, very few followers until the &lsquo;90s. So there really was a kind of period in the wilderness in the 1980s when there was just a handful, three, four, five people actively doing behavioural economics.<o:p></o:p></p>
<p class="MsoNormal"><o:p></o:p>And then in the &rsquo;90s, life really got started in terms of more and more people signing on to this endeavour. And now, I think it&rsquo;s an area that has a great deal of interest, enormous graduate student interest, and a lot research taking place. You could almost say it's become a fad. <o:p></o:p></p>
<p><strong>Romesh:</strong> [laughs] So, tell me a little more about how this actually developed. I mean, I guess, for years and years non-economists have said, &ldquo;You guys, you have this very, very peculiar view of human nature.&rdquo; So that's been around for a long time. What was it that suddenly made it possibly to introduce psychology? Was it something to do with the tools, the methodology and the techniques that economics has developed? <o:p></o:p></p>
<p class="MsoNormal"><o:p></o:p><strong>David:</strong> Yeah. That's a great question. I think there were two things that happened during the last 25 years. The first thing was we began to find empirical evidence that contradicted the Rational Actor model. Now, just to be clear, no economist today, or 50 years ago, believes that people are truly perfectly rational. What economists have always said is that the Rational Actor model was a good approximation. It got things mostly right. Just like a map gets things mostly right. It may miss out the hills and valleys in <st1:city w:st="on">London</st1:city>, but the map basically tells you how <st1:city w:st="on"><st1:place w:st="on">London</st1:place></st1:city> is laid out. Well, a map can be useful, can be nearly right, even if it's not perfectly right. Just like the Rational Actor model, was always felt to be a very good approximation of how people behave.<o:p></o:p></p>
<p class="MsoNormal">But, in the last few decades, more and more evidence, whether it's experimental evidence in the laboratory, or evidence from the field in real markets, has contradicted in very powerful, fundamental ways, many of the predictions of that Rational Actor model. And as these contradictions piled up, we became more and more interested in finding alternatives.<o:p></o:p></p>
<p class="MsoNormal"><o:p></o:p>So that was one set of developments. The other set of developments is that we have developed a theoretical framework or a set of theoretical frameworks that enable us to formalize these departures. So, economists have always said, &quot;Look, I know people aren't perfectly rational, but the only model we have is the Rational Actor model and it does a pretty good job.&quot; I would agree.<o:p></o:p></p>
<p>However, now we have alternative models. We have other ways of formalizing, of mathematically representing human behavior. And they don't leave the Rational Actor model aside, they add to it. They improve it. They supplement it. And I think now we have a combination of new data and supplemental models that are jointly moving economics ahead. <o:p></o:p></p>
<p class="MsoNormal"><o:p><strong>R</strong></o:p><strong>omesh: </strong>Now, your own research program is very much focused on peoples&rsquo; decisions about savings and investment, I understand. And that's what you're lecturing about this week. I guess this touches on a huge policy issue for western countries, the whole challenge of getting people to save enough to pay for their old age. What kind of findings are you coming up with and what lessons can we learn from them? <o:p></o:p></p>
<p class="MsoNormal"><strong>David: </strong>So, there are kind of two bodies of thinking in my research. The first is to understand the fundamental essence of how humans make decisions. And the second is to think about, once we have that human tendency in hand, how do we build institutions that help people do what they want to do? So, the underlying psychology is the psychology of instant gratification. The psychology of a decision maker, of a household, that puts enormous weight on the present, and then drastically discount events that might even be a week away in time. It's the person who says, &ldquo;I know I should exercise, and I'll do that next week, but right now, these chips look very good.&rdquo;<o:p></o:p></p>
<p>Or the person who says, &ldquo;I know I should save, and I'll start saving very seriously next month, but tonight, how about a bottle of champagne.&rdquo; So this psychology can be modeled, can be measured. And I spent a lot of my academic career trying to do exactly those things. But then the question arises, well, if people do put enormous weight on the present, it might be awfully hard for them to save.<o:p></o:p></p>
<p class="MsoNormal">Now, we see humans, people, generally caring a lot about the future. They say, &ldquo;Look, I'm not going to save today, but I will save tomorrow. I'm not going to exercise now, but I will exercise later.&rdquo; So we do care about our futures. It's not as if we think that they're irrelevant, but we aren't willing to invest in the future right now.<o:p></o:p></p>
<p class="MsoNormal"><o:p>W</o:p>e prefer to make those investments next month. So we need to build institutions that help get us over that hump. And a lot of the work that I'm doing is trying to figure out how to create, say pension plans or saving systems, that help people save for retirement. People who might not be able to do it on their own, but are thrilled when you make it easier for them by providing, say, a defined contribution pension plan.<o:p></o:p></p>
<p class="MsoNormal"><o:p></o:p>This would be a system, say where, you're a new employee in a firm, you're automatically enrolled in the pension scheme, some fraction of your salary is deposited every month on a regular basis, directly from your paycheck into this account. These plans are highly effective. People like them. People stay in them.<o:p></o:p></p>
<p>They don't opt out of them. They accumulate large bodies of wealth for retirement. And yet, if you change the system, and the person, instead of being automatically enrolled, is instead given the option to enroll, and is unenrolled if they do nothing, you find that very few people enroll. It takes years for the typical median person to enroll in the plan.<o:p></o:p></p>
<p class="MsoNormal">So we have this interesting system where, our tendency to weight the future very heavily, to procrastinate, undermines our willingness to save. And one natural way around that is to make savings automatic. When you do that, people are very happy.<o:p></o:p></p>
<p class="MsoNormal"><o:p>S</o:p>o, a lot of what I'll be talking about in these lectures is describing both the underlying psychology of resisting savings and the institutions - that are very easy to implement that are now being widely adopted - that help people save; which is what they tell us they want to do anyway. <o:p></o:p></p>
<p class="MsoNormal"><o:p></o:p><strong>Romesh: </strong>So, in a way, your work is informing policy that will sort of save people from themselves? <o:p></o:p></p>
<p class="MsoNormal"><strong>David: </strong>That's exactly right. Though, we don't want to be too paternalistic. I'm an advocate of giving people good defaults and always giving them the option to opt out if they don't want to. I recognize that government sometimes goes too far and we don't want to tell people how to live their lives. But I also recognize that left to their own devices completely, people sometimes make bad choices.<o:p></o:p></p>
<p class="MsoNormal"><o:p></o:p>So, we need to find a middle ground. A hybrid system that nudges people in the right direction that encourages them to do things that they view as desirable without forcing them, without compelling them or coercing them in ways that we deem to be too paternalistic or heavy handed. <o:p></o:p></p>
<p class="MsoNormal"><o:p></o:p><strong>Romesh: </strong>So, in a way, you want to help people with their savings with this kind of encouragement? But there must be a role for education as well, isn't there? We see certainly in this country and I'm sure it's the same in the States, so few people have a grasp of basic numbers. So, how can they have a grasp of managing their finances effectively? Is there a role there as well? <o:p></o:p></p>
<p class="MsoNormal"><o:p>&nbsp;</o:p><strong>David: </strong>Well, it's true. People have very low levels of financial literacy or financial capability, which is a word that's often used here. And a lot of the work that I've been doing with my collaborators - John Beshears, James Choi, Brigitte Madrian, Andrew Metrick - has been studying these financial vulnerabilities, in terms of low levels of education or knowledge about finance. But if we think that education is an important piece of the puzzle, we have to not only document that education is missing, but also show that educating people leads them to behave in better ways. And surprisingly, there's very little evidence that supports that kind of policy: meaning, it's not clear that programs that provide education increase peoples' financial literacy and improves their behaviour in ways that are cost effective. So it&rsquo;s true that if we gave everyone a PhD in finance, we'd probably see the world saving much more correctly and investing more rationally. But that's an awfully expensive intervention.<o:p></o:p></p>
<p class="MsoNormal"><o:p>&nbsp;</o:p>Then the question becomes, can we strip it down and generate much simpler, cheaper, quicker interventions that get the job done on the education front? And the answer so far is maybe not. It doesn't look like there are easy educational interventions that train people to make optimal financial decisions. Now for example, even if we had a high school curriculum &ndash; which I think is a good idea &ndash; that emphasized more economic issues and that emphasized more financial issues, it might well be the case that by the time that 18 year old became 48, the world will have changed. And what she learned in high school may no longer be that relevant for what she will have to do as an adult.<o:p></o:p></p>
<p class="MsoNormal"><o:p></o:p>If I had been taught how to save for retirement when I was in high school, I would have been taught find a company with a good defined benefit pension plan and work there for the rest of your life. And it turns out, that was terrible advice, because all of those plans are being terminated, first of all. And second of all in the job market of today you don't stay at one company your whole life, you move around. And if you move around - as you should to advance in your career - you're going to lose those pension benefits.<o:p></o:p></p>
<p class="MsoNormal"><o:p></o:p>So, if we think education is important, we have to first document that we actually can cost effectively educate people and help them make better choices.<o:p></o:p></p>
<p class="MsoNormal"><o:p></o:p>I actually think that &ldquo;automaticity&rdquo; is a much more effective tool in helping people make good choices. Rather than spending a lot of time and energy to educate someone which may or may not get them to make a better choice, I know that if I automatically enrol them in a pension plan, in a defined contribution pension plan. And I put them in at a five or six or seven percent savings rate and I automatically allocate their assets to a life cycle fund, they're going to do beautifully. And they're going to basically stick with my good default.<o:p></o:p></p>
<p class="MsoNormal"><o:p></o:p>So I have a question. Do I want to spend thousands of dollars on education for that person? Or do I want to automatically enrol them in the pension plan with the default savings rate of 7% and the default asset allocation to a life cycle fund with a default fund with relatively low fees. I know the latter works. It still remains to be shown that the education works. <o:p></o:p></p>
<p class="MsoNormal"><o:p></o:p><strong>Romesh:</strong> Interesting. Now, the other word that you have in your title is the psychology of investment. I guess when people think about the psychology of investment they think about asset markets going crazy. [laughter] As they have been to some degree in recent months. What kind of things are you looking at there? What kind of issues are you thinking about in terms of the psychology of investors? <o:p></o:p></p>
<p class="MsoNormal"><o:p></o:p><strong>David: </strong>Well, I believe that a lot of the investment choices that the typical investor makes are self defeating. Whether it's return chasing; whether it's avoiding risks because of psychological loss aversion; whether it's failing to recognize the importance of fees in reducing returns. Again and again economists as well as me and my collaborators are documenting that people make mistakes. I think we have to both recognize what those mistakes are, understand their sources, and also build institutions that help them avoid those mistakes.<o:p></o:p></p>
<p class="MsoNormal"><o:p></o:p>So, that's where the investment side comes in. I think that it's easy to make bad choices in financial markets: choosing the wrong mutual funds, choosing the wrong asset classes, failing to diversify, failure to hold a world portfolio, instead just holding a domestic portfolio. I think that the typical investor needs a lot of help; both perhaps education and perhaps through defaults to improve their balance sheet.<o:p></o:p></p>
<p class="MsoNormal"><o:p></o:p>Another issue that I haven't even mentioned now is employer stock. In the <st1:country-region w:st="on"><st1:place w:st="on">U.S.</st1:place></st1:country-region> investors in these defined contribution pension plans often hold an alarmingly high fraction of their wealth in employer stock, which of course is putting all your eggs in the same basket. You don't want your job to be on the line and your retirement account to collapse at the same time, which is exactly what happened of course at Enron and many other firms in the early 2000s. So we've got a lot to do in measuring and then understanding the psychological underpinnings of these mistakes; which of course will lead us to build better institutions that help people avoid these mistakes. <o:p></o:p></p>
<p class="MsoNormal"><o:p></o:p><strong>Romesh: </strong>So, following on from that a final question, David. What kind of impact are the research findings that you and your colleagues in this field starting to have on policy makers? Whether they're in government or in business or investment houses. This kind of idea's starting to feed in no doubt into practice, but probably...<o:p></o:p></p>
<p class="MsoNormal"><o:p></o:p><strong>David: </strong>Very, very happily it has had - the work that we're doing and the work of many other economists in this field - have had a large effect on what&rsquo;s going on in financial markets and on the part of regulators, both in the U.S. and around the world. So the <st1:country-region w:st="on">U.S.</st1:country-region> just passed the pension protection act which basically made defaults the official policy of the <st1:country-region w:st="on"><st1:place w:st="on">U.S.</st1:place></st1:country-region> government. Using defaults to help people save in retirement accounts. The Department of Labor recently introduced regulations that establish what is and what is not an appropriate investment for these default funds.<o:p></o:p></p>
<p class="MsoNormal"><o:p></o:p>The <st1:place w:st="on"><st1:country-region w:st="on">U.K.</st1:country-region></st1:place> is about to initiate its own major policy program using defaults. And we're seeing them showing up in many, many countries around the world. So, the joint recognition that: (a) investors sometimes make mistakes and (b) institutions that aren't that complex or that controversial can avoid a lot of these problems - I think are jointly winning the day.<o:p></o:p></p>
<p class="MsoNormal"><o:p></o:p>And I'm happy to say that I think the pensions' world of 2010 is going to look a lot different and a lot more practical and useful to unsophisticated investors than the pension world of 2000. <o:p></o:p></p>
<p class="MsoNormal"><o:p></o:p><strong>Romesh: </strong>David Laibson, thank you very much. <o:p></o:p></p>
<p class="MsoNormal"><strong>David: </strong>Thank you.&nbsp;</p>
<p class="MsoNormal">&nbsp;</p>

Topics:  Financial markets Institutions and economics Welfare state and social Europe

Tags:  institutions, savings and investment decisions, psychology

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Robert I. Goldman Professor of Economics, Harvard University


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