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Psychological Impediments to Retirement Planning. Elke U. Weber Center for the Decision Sciences Columbia University Dartmouth College Financial Education Workshop October 2005. Retirement Planning and Investing as Risk Management.

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Psychological impediments to retirement planning l.jpg

Psychological Impediments to Retirement Planning

Elke U. Weber

Center for the Decision Sciences Columbia University

Dartmouth College Financial Education Workshop

October 2005

Retirement planning and investing as risk management l.jpg
Retirement Planning and Investing as Risk Management

  • Economic and social costs of insufficient savings or suboptimal investments are huge

    • Personal as well as societal implications

  • Yet, few of us lose sleep over it

    • True for general public, politicians, and even experts/researchers/practitioners who know better

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  • Why aren’t people motivated to engage in retirement planning?

    • Motivational impediment: insufficient fear

  • Assuming we could motivate them to care, would/could they do a good job?

    • Other (cognitive and affective) impediments

  • Financial education and policy implications

Two processing systems epstein 1994 kahneman 2002 sloman 1996 and others l.jpg
Two processing systemsEpstein, 1994; Kahneman, 2002; Sloman, 1996; and others

  • Analytic, algorithmic, rational, rule-based system

    • effortful, slow, requires conscious awareness, and knowledge of rules

      • e.g., probability calculus, Bayesian updating, formal logic

  • Association- and similarity-based system

    • evolutionarily older, hard-wired, fast, automatic

      • greater emphasis on outcomes than probabilities

      • emotions as a powerful class of associations

    • two systems operate (in parallel)

      • joint operation rises to awareness only when system output is in conflict

      • when output of systems in conflict, behavior typically determined by associative/affective processing system

        • (Loewenstein, Weber, Hsee & Welch, 2001)

  • Motivational impediments to retirement planning l.jpg
    Motivational impediments to Retirement Planning

    • Affect is the wellspring of action

      • Emotions are evolution’s way to get us to do things that are good for our survival and reproductive success

        • Positive emotions want to be maintained

        • Negative emotions (fear, anxiety) act as an early warning system that triggers protective action

          • “…woe speaks: ‘cease, go,’ but all lust wants eternity, wants deep, deep, deep eternity…” Nietzsche

      • Without feeling of being at risk, we fail to allocate attentional and material resources to risk management

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    • Affective or visceral reactions to the risks of inadequate pension savings are low

      • Psychological risk dimensions shape risk perception in health and safety situations

        • Reducible to two dimensions: predictability and dread (Fischhoff, Slovic, Lichtenstein, Read, & Combs, 1978; Slovic, 1987)

        • “Dread”/affective component predicts risk perceptions of financial investments by U Chicago MBA students above and beyond probability distribution of possible outcomes

          • Holtgrave & Weber, 1993

      • Risk of inadequate pension-saving scores low on both psychological risk dimensions

        • thus fail to elicit subjective feeling of being at risk

    Should we scare people into worrying more about their old age financial security l.jpg
    Should we scare people into worrying (more) about their old-age financial security?

    • Two downsides to affect-based decisions

      • Finite pool of worry effect

        • As concern about one type of risk increases, worry about other risks decreases

        • Capacity to worry seems to be relatively fixed and takes time to regenerate (Linville & Fischer, 1991; Hansen, Marx, Weber, 2004)

        • Raising worry/concern in one area by making it vivid or concrete may decrease or displace valid concerns in other domains

          • Terrorism vs. civil liberties and environment

      • Single action bias

        • decision makers will take one action to reduce a risk that they fear, but are less likely to take additional steps that would provide incremental protection or risk reduction

        • presumably first action suffices in reducing the feeling of fear or threat

          • observed in medical diagnosis, farmers’ reactions to climate change (Weber, 1997)

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    Other psychological impediments old-age financial security?

    • (Hyperbolic) discounting of delayed costs and benefits

    • Finite cognitive capacity

      • Inability to deal with too much choice

    • Difficulty understanding probabilistic information

    • Insufficient diversification/Home bias

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    (Hyperbolic) discounting of delayed costs and benefits old-age financial security?

    • Immediate consumption (small benefit now, large cost later) preferred over later consumption (large benefit later, small cost now)

      • Lack of self-control

        • Initially observed in children (Mischel et al., 1969), also in adults (Kirby & Herrnstein, 1995) and other animals (Ainslie & Herrnstein, 1981)

      • Modeled by hyperbolic discounting (Loewenstein & Prelec, 1992; Rachlin et al., 1991)

        • Discounting strongest for immediate consumption deferral from now to now + k

      • Explained by

        • preference construction processes (Weber & Johnson, 2005; Weber et al. 2005)

          • Immediate consumption considered first, with richer representation

        • mental representation of present vs. future events (Trope & Liberman, 2003)

          • Future: abstract; Present: concrete, affect-laden

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    Finite cognitive capacity old-age financial security?

    • Cognitive constraints recognized as source of many human heuristics and biases

      • Limited working memory and attention give rise to bounded rationality (Simon, 1990)

      • Economic assumption that “more choice is always better” not true

        • Quality of choices and satisfaction with choices often reduced when number of choice options increase over the magical number 7 (±2) (Iyengar & Lepper, 2000)

        • Shown to apply to selection of contributions to 401(k) retirement plans (Iyengar, Huberman, & Jiang, 2004)

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    Difficulty understanding probabilistic information old-age financial security?

    • Quantification of uncertainty into probabilities allows for communication, i.e., for its transmission to others

      • Allows for vicarious learning, an evolutionary advantage

      • Yet, concept of “probability” and probability theory a recent human accomplishment (conducted by our analytic, rule-based processing system)

        • Prospect theory (Kahneman & Tversky, 1979) and support theory (Tversky & Koehler, 1994; Tversky & Fox, 1995) formalize how people’s use of probabilities falls short

        • Decisions from statistical description often deviate from decisions from personal experience (Hertwig, Barron, Weber, & Erev, 2004, 2005)

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    • Decisions from Description old-age financial security?

      • Outcome distribution fully described

        • possible outcomes and their probabilities provided numerically or graphically

        • almost exclusively studied in human choice

          • 226 of 226 data sets in meta-analysis of Weber, Shafir, Blais (2004)

      • Extensive use of analytic, rule-based processing system

      • People overweight small-probability events (Kahneman & Tversky, 1979, Tversky & Kahneman, 1992)

    • Decisions from Experience

      • Outcome distribution initially unknown

        • knowledge of possible outcomes and their likelihood acquired by personal exposure in repeated choices

      • Extensive use of associative, affective processing system

        • Recent events get disproportionate weight

      • People underweight small probability events, unless they just occurred, in which case they overreact (Hertwig et al., 2004, 2005)

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    Insufficient Diversification/Home Bias old-age financial security?

    • Two common investment mistakes that are based in affective reactions

      • Insufficient Diversification

        • People underinvest in options that have negative correlations in their expected returns with current holdings

        • Aversive to discover losers in one’s portfolio each period

        • Diversified investment assets judged to be riskier than undiversified ones (Weber, Siebenmorgen, & M. Weber, 2005)

      • Home Bias

        • Investors hold far too little of their financial portfolios in foreign investments, despite large potential gains from international diversification (Cooper & Kaplanis, 1994)

        • Behavioral explanations show that the greater familiarity of domestic investments breeds greater liking (Huberman, 2001) or greater perceived competence (Kilka & M. Weber, 2000)

        • These positive feelings translate into perceptions of smaller risk (Weber, Siebenmorgen, & M. Weber, 2005) and therefore more likely investment selection

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    So how to proceed? old-age financial security?

    • On multiple fronts

    • Active decisions are problematic

      • Psychological risk dimensions (e.g., voluntary risk) fail to elicit affective early warning signal that would trigger action

      • Decisions from experience make risks seem small

    • Important to design decision environment in helpful ways

      • Liberal paternalism (Sunstein & Thaler, 2003)

        • Creative use of defaults (Benartzi & Thaler, 2004; Johnson & Goldstein, 2003)

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    Implications for Aiding Investment Decisions old-age financial security?

    • Three classes of decisions

      • Class 1: Decision to save and how much

      • Class 2: Choice between plan providers and investment vehicles

      • Class 3: Decision to periodically examine and rebalance investment portfolio

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    Class 1 old-age financial security?: Decision to save and how much

    • Diagnosis 1

      • Contemplating old-age and retirement and infirmity is aversive

      • Aversiveness results in avoidance behavior

    • Recommendation

      • Use defaults that turn avoidance behavior (passivity) into a virtue (Benartzi & Thaler, 2004)

    • Diagnosis 2

      • Abstract representation of distant future consequences fails to arouse fear/concern/anxiety

    • Recommendation

      • Concretize consequences of possible decisions

        • through simulation tools like the Distribution Builder (Goldstein, Johnson, & Sharpe, 2005)

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    Stocks old-age financial security?


    The $1,776,000,000,000 question






    Interest Rates

    Inflation Rates














    Probability Distribution

    Of Wealth

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    Framework for experiencing risk-return tradeoffs old-age financial security?

    Income levels (% of pre-retirement income)


    100 moveable people, one

    of which represents the user

    (experienced frequency

    representation of probability)

    Typical level of

    retirement income

    (Perceived loss point)

    Minimum level

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    Class 2 old-age financial security?: Choice between plan providers and/or investment vehicles

    • Diagnosis 1

      • Naïve diversification can be problematic

    • Recommendation

      • Design categories such that 1/n heuristic will lead to desirable portfolio

    • Diagnosis 2

      • Too much choice can immobilize decision makers

    • Recommendation

      • Arrange information hierarchically

    Class 3 decision to examine and rebalance investment portfolio l.jpg
    Class 3 old-age financial security?: Decision to examine and rebalance investment portfolio

    • Diagnosis

      • Such action will not be triggered by affective processing system

        • Task is boring and inaction is not scary

    • Recommendation

      • Establish habit for periodic reevaluation

        • Repetitive indoctrination of simple rule

          • Like flossing and seat-belt usage

        • Take away inaction as the status quo

          • Legislation/fines or beneficial defaults

    So how to proceed22 l.jpg
    So how to proceed? old-age financial security?

    • On multiple fronts

      • education and experiential interactions that concretize and dramatize future consequences can help, but….

    • Active decisions are problematic for multiple reasons

      • Decision environment can be designed in helpful ways to make people’s heuristics and biases work for them, rather than against them

    References l.jpg
    References old-age financial security?

    • Ainslie, G., & Herrnstein, R. J. (1981). "Preference reversal and delayed reinforcement." Animal Learning & Behavior, 9, 476-482.

    • Cooper, I. & Kaplanis, E. (1994). Home bias in equity portfolios, inflation hedging, and international capital market equilibrium. Review of Financial Studies, VII, 45-60.

    • Epstein, S. (1994). Integration of the cognitive and the psychodynamic unconscious. American Psychologist, 49, 709-724.

    • Fischhoff, B., Slovic, P., Lichtenstein, S., Read, S., & Combs, B. (1978). How safe is safe enough? A psychometric study of attitudes towards technological risks and benefits. Policy Sciences, 9, 127‑152.

    • Hertwig, R., Barron, G., Weber, E. U., & Erev, I. (in press). Rare risky prospects: Different when valued through a window of sampled experiences. In K. Fiedler & P. Juslin (Eds.), Information sampling as a key to understanding adaptive cognition in an uncertain environment. New York, NY: Cambridge University Press.

    • Hertwig, R., Barron, G., Weber, E. U., & Erev, I. (2004). Decisions from experience and the effect of rare events. Psychological Science, 15, 534-539. (Editor’s Choice for “Highlights of the Recent Literature” in Science, 305, 452; see

    • Holtgrave, D. & Weber, E. U. (1993). Dimensions of risk perception for financial and health risks. Risk Analysis, 13, 553‑558.

    • Kahneman, D., & Tversky, A. (1979). Prospect theory: An analysis of decision under risk. Econometrica, 47(2), 263-291.

    • Hansen, J., Marx, S., Weber, E. U. (2004). The Role of Climate Perceptions, Expectations, and Forecasts in Farmer Decision Making: The Argentine Pampas and South Florida. International Research Institute for Climate Prediction (IRI), Palisades, NY: Technical Report 04-01.

    • Huberman, G. (2001). Familiarity breeds investment. Review of Financial Studies, XIV, 659-680.

    • Iyengar, S. S., & Lepper, M. (2000). When choice is demotivating: Can one desire too much of a good thing? Journal of Personality and Social Psychology, 76, 95-1006.

    • Iyengar, S. S., Huberman, G., & Jiang, W. (2004). How much choice is too much? Contributions to 401(k) retirement plans. In O. S. Mitchell & S. P. Utkus (Eds.), Pension Design and Structure: New Lessons from Behavioral Finance. Part I. Research on Decision-Making Under Uncertainty (pp. 83-96). Oxford, UK: Oxford University Press.

    • Kahneman, D. (2002). Nobel Lecture.

    • Kilka, M. & Weber, M. (2000). Home Bias in International Stock Return Expectations. Journal of Psychology and Financial Markets, I, 176-192.

    • Kirby, K. N. and R. J. Herrnstein. (1995). “Preference Reversals due to Myopic Discounting of Delayed Reward,” Psychological Science 6, 83-89.

    • Loewenstein, G. F., Prelec, D.Anomalies in intertemporal choice: Evidence and an interpretation.Quarterly Journal of Economics, 107(2): 573-597.

    • Mischel, W., Grusec, J., & Masters, J. (1969). Effects of expected delay time on the subjective value of rewards and punishments. Journal of Personality and Social Psychology, 11, 363-373.

    Slide24 l.jpg

    • Leiserowitz, A. (2004). "Suveying the Imapct of "The Day After Tomorrow"." Environment 46(9): 23-44.

    • Linville, P. W. and G. W. Fischer (1991). "Preferences for separating and combining events: A social application of prospect theory and the mental accounting model." Journal of Personality and Social Psychology Bulletin(60): 5-23.

    • Loewenstein, G. F., Weber, E. U., Hsee, C. K., Welch, E. (2001). Risk as feelings. Psychological Bulletin, 127, 267-286.

    • Simon, H.A. (1990). Invariants of human behavior. Annual Review of Psychology, 41, 1-19.

    • Sloman, S. A. (1996). The empirical case for two systems of reasoning. Psychological Bulletin, 119(1), 3-22.

    • Slovic, P. (1987). Perception of risk. Science, 236, 280-285.

    • Slovic, P. (1997). Trust, emotion, sex, politics, and science: Surveying the risk-assessment battlefield. In M. Bazerman, D. Messick, A. Tenbrunsel, & K. Wade-Benzoni (Eds.), Psychological Perspectives to Environmental and Ethical Issues in Management

    • (pp. 277-313). San Francisco, CA: Jossey-Bass.

    • Sunstein, C. R. & Thaler, R. H. (2003). Liberal Paternalism is not an Oxymoron. University of Chicago Law Review

    • Trope, Y. & Liberman, N. (2003). Temporal Construal. Psychological Review, 110, 403-421.

    • Tversky, Amos & Fox, Craig R. (1995), "Weighing Risk and Uncertainty,“ Psychological Review 102, 269-283.

    • Tversky, A. & D. Kahneman (1992): Advances in prospect theory: Cumulativerepresentation of uncertainty. Journal of Risk and Uncertainty, 5, 297-323.

    • Tversky, A., & Koehler, D. J. (1994). Support theory: a nonextensional representation of

    • subjective probability. Psychological Review, 101, 547-567.

    • Weber, E. U. (1997). Perception and expectation of climate change: Precondition for economic and technological adaptation. In M. Bazerman, D. Messick, A. Tenbrunsel, & K. Wade-Benzoni (Eds.), Psychological Perspectives to Environmental and Ethical Issues in Management (pp. 314-341). San Francisco, CA: Jossey-Bass.

    • Weber, E. U. (2004). The role of risk perception in risk management decisions: Who’s afraid of a poor old-age? In O. S. Mitchell & S. P. Utkus (Eds.), Pension Design and Structure: New Lessons from Behavioral Finance. Part I. Research on Decision-Making Under Uncertainty (pp. 53-66). Oxford, UK: Oxford University Press.

    • Weber, E. U. (2004). Perception Matters: Psychophysics for Economists. In J. Carrillo and I. Brocas (Fds.), Psychology and Economics (pp. 165-176). Oxford, UK: Oxford University Press.

    • Weber, E. U. & Johnson, E. J. (2005). Constructing preferences from memory. In: Slovic, P., & Lichtenstein, S. (Eds.), The Construction of Preference. New York NY: Cambridge University Press, in press

    • Weber, E. U., Johnson, E. J., Milch, K., Chang, H., Brodscholl, J., & Goldstein, D. Asymmetries in discounting in intertemporal choice: A query theory account. In preparation for Psychological Science..

    • Weber, E. U., Siebenmorgen, N., Weber, M. (2005). Communicating asset risk: How the format of historic volatility information affects risk perception and investment decisions. Risk Analysis, in press.