February 1, 2008

Academic Studies On Participant Behavior

As a part of our support for academic research concerning participant investment behavior (including our support of research by Professor Shlomo Benartzi of UCLA), we regularly post important academic and industry studies on our website.

We have recently posted a study entitled “Red, Yellow, and Green: A Taxonomy of 401(k) Portfolio Choices.” The authors summarize the study as follows:

One measure of financial literacy is the quality of portfolio decision-making in 401(k) plans. Applying a qualitative framework to a dataset of nearly three million 401(k) accounts, we estimate that 43% construct “green” portfolios with balanced exposure to diversified equities, while 26% construct “yellow” portfolios with possibly too-aggressive or too-conservative equity holdings. Another three in 10 participants make egregious errors and have “red” portfolios-either holding zero in equities or over concentrating their account in employer stock. Using a subset of our sample, we estimate the costs of portfolio errors (and the potential gain from improved allocations) at roughly 60 to 350 basis points in expected real return per year, depending on the initial portfolio held. Low income, low wealth and female participants are more likely to experience the largest gains from better portfolios, given their tendency to hold less aggressive portfolios.

To put this study in context, most industry data shows that 401(k) plans are invested about 65% in equities and about 35% in fixed income, which seems balanced and reasonable. However, when the analysis is done at the account level, rather than the plan level, it turns out that part of the average is based on accounts that are invested too conservatively and accounts that are invested too aggressively. In other words, the averages mask the problem.

Hopefully, the current focus on target maturity funds, risk-based lifestyle funds and managed accounts will help solve the problem.

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