June 1, 2010
A study by economists Henrik Cronqvist of Claremont McKenna College and Richard Thaler of the University of Chicago found that the Swedish government may have been misguided in steering investors away from the default fund. On average, investors who chose their own plans underperformed the default fund by 10 percent after three years, and by 15 percent after seven. The investors who selected their own funds, they found, tended to choose investments that were familiar to them from their daily lives, rather than build a diversified portfolio that was tailored to their financial interests. They put all their money into stocks, for example, while ignoring bonds and other assets. Many invested too heavily in Swedish stocks, or in their own companies, or in stocks that were hot at the time.
Politically, findings like these lead Iyengar and other behavioral economists toward a soft paternalism. By setting sensible defaults and doing nothing to actively discourage people from choosing those defaults, they say, experts and bureaucrats can help the average person meet his needs better than he could himself, if left to his own devices.
These arguments, of course, run counter to traditional economic thought. A mainstream, neoclassical economist would argue that there should be no “default options” chosen from above. Allow every retirement fund to vie for the attention of investors on equal footing, mainstream economic theory says, and competition will drive down prices and eliminate inferior products. Default options will only lead to distortions and inefficiency. If there are specific instances in which a single expert or group of experts knows more than the rest of the market, those cases are the exceptions, not the rule. The track record of government-appointed money managers, after all, is far from perfect. Just look, for example, at how poorly state and local pension assets have performed in the U.S. over the past few years.
Furthermore, a mainstream economist would argue in response to the Sweden example, seven years of returns from a single investment fund aren't enough to prove anything. Indeed, it's ludicrous to think that experimental results or cases studies could “prove” anything at all in economics, as they do in the natural sciences. The country of Sweden has nothing even approaching the controlled, replicable conditions of a chemistry or physics lab. From politics to education to cultural norms, there are simply too many variables at play. It is therefore best to ask what a rational person would do in any given situation, and use that as a best first guess for the future, not some rule of thumb drawn from dubious experimental results.
Because of caveats like these, behavioral economics remains an interesting corollary to the neoclassical mainstream, rather than the basis for a wholesale paradigm shift. But that won't stop businesspeople from trying to put findings like Iyengar’s into practice. Indeed, as the author notes, the head of Fidelity Research told her that he took her jam study as a sign that his financial services company needs to narrow down the selection of more than 4,500 mutual funds it offers to clients. One executive at McKinsey, a management consulting firm, said he used her findings to create his company's “3x3 rule,” which stipulates that potential clients first choose from a selection of three choices, then another set of three choices, followed by no more than a third set of three choices during sales pitches.
If Iyengar's book strikes a chord, others will surely follow.
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