How do investors prefer to save for their pensions: the 1/N heuristic.

How do investors prefer to save for their pensions: the 1/N heuristic.

Mark and Harvey were sat having coffee in their regular café that they visited every Thursday for breakfast before work. They discussed the latest football results and eventually ended up on the subjects of retirement. Harvey had never got around to starting an investment for his retirement so wanted to ask Mark for advice. Mark simply suggested that Harvey allocate his retirement investments equally across several funds, explaining that this reduce risk.

Saving or investing for retirement is one of the most important decisions that a person can make in their lifetime. Picking the right pension plan and / or allocating resources to the right fund(s) is crucial for enjoying their retirement years. Pension plans and retirement schemes differ from country-to-country. In some pension schemes investors have the choice of how to allocate their funds. When planning for their retirement individuals with a pension plan that allows them to allocate resources to different funds must choose how to invest their money. One popular strategy for making decisions about how to allocated resources is to use the 1/N heuristic (Benartzi & Thaler, 2001). The 1/N heuristic removes the confusion and stress of weighing up the pros and cons of how to invest resources and simply states that a given amount of resources should be divided equally between ‘x’ funds, for example, when a sum of £100,000 is to be invested this would be distributed into £20,000 into 5 different funds.

In the Swedish pension system investors have the option of deciding how to invest 2.5% of their income. They can allocate 2.5% of their income to either a stock or interest fund (Hedesstrom et al., 2007). Once an individual makes the decision to invest part of their income they receive a brochure with 655 potential funds, they are then required to decide which of the funds they’d like to invest in. In 2004 researchers at Goteborg University analysed 392 investment decisions. The researchers found that investors used at least 5 different heuristics and biases to make their decisions. Investors had a tendency to avoid funds with extreme high and low risks (extremeness aversion – Simonson & Tversky, 1992), a tendency to select the default option (default bias – Johnson et al., 1992), to choose many funds in an attempt to seek maximal variety (diversification heuristic – Read & Loewenstein, 1995), to select domestic funds (home bias – Kilka & Weber, 2000), and to use the 1/N heuristic (Benartzi & Thaler, 2001).

A larger study of more than half a million pension plan participants in Defined Contribution pension plans from the records of the Vanguard Group investigated the use of the 1/N heuristic (Huberman & Jiang, 2004). They found that when deciding how to allocate pension funds participants tended to use the 1/N to divide their funds over 3 or 4 funds.

A third study of 1000 people examined how Dutch citizens planned for their retirement (Van Rooij et al., 2007). After analysing retirement decisions the results of this study revealed that Dutch citizens are risk-averse and considered themselves to be financially unsophisticated. When given the option these investors used one three strategies (i) the default bias, (ii) the 1/N heuristic, or were susceptible to (iii) framing.

So, depending on what country you work in and decide to retire to there are many different ways to prepare for your retirement. Since most of us, like Harvey, are not financial experts when given complex important decisions to make for our retirement we choose to avoid risk by allocating our money equally across several funds by using the 1/N strategy. When planning for retirement the 1/N heuristic can be an effective and useful way to decrease risk and ensure a substantial retirement fund.

So, depending on what country you work in and decide to retire to there are many different ways to prepare for your retirement. Since most of us, like Harvey, are not financial experts when given complex important decisions to make for our retirement we choose to avoid risk by allocating our money equally across several funds by using the 1/N strategy. When planning for retirement the 1/N heuristic can be an effective and useful way to decrease risk and ensure a substantial retirement fund.