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.

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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.

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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.

The framing effect in bonobos, chimpanzees and capuchin monkeys.

The framing effect in bonobos, chimpanzees and capuchin monkeys.

Noam Chimpsky had had a long day playing with the other chimpanzees. Noam was starting to feel hungry so headed towards the eating area of his enclosure. He had previously stored some fruit on a branch of a large tree. On the way to collect his fruit Noam noticed that one of the other chimpanzees had a new fruit that he had never seen before. Noam was determined to try some of the new fruit. He collected some of his fruit from his stash of fruit and went towards the other chimpanzee who was still carrying the new fruit. Noam wanted to trade some of his fruit for the new fruit. He stopped in front of the other chimpanzee, placed his fruit on the ground and tried to trade. The chimpanzee with the new fruit was happy to trade but wanted more fruit then Noam was willing to give. Noam decided that trading was a bad idea if he had give away too much fruit so he went off to his tree, with his fruit in hand and settled down to eat – afterall, Noam could try some of the new fruit another day.

Noam’s choice was to trade a small amount of food for the new fruit or to trade a lot of his fruit for the new fruit. In the end, Noam decided that the new fruit was not worth a lot of his fruit. Like humans Noam is susceptible to the framing effect. For Noam, his dilemma was to accept a negatively framed trade were he would lose out by giving away too much of his fruit or to broker a positively framed trade were he would give away a small amount of fruit for the new fruit.

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The framing effect states that the manner in which options are presented (or framed) can influence how we evaluate choices. We evaluate the options relative to a reference point (i.e., the amount of fruit the Noam had to start with). Changes that seem to worsen the status quo (i.e., Noam giving away a lot fruit for the new fruit) are treated differently to changes that improve the status quo (i.e., Noam gaining the new fruit after trading for a small amount of fruit). The way in which we (and Noam) perceive the choice is important because we are more willing to invest in a choice that is positively framed, rather than negatively framed. The framing effect has been documented extensively in human decision-making in areas such as financial trading (Seo et al., 2010) and medical decision-making (Bornstein et a., 2001). However, as we have seen in the case of Noam other animals, other than humans also exhibit the framing effect. According to molecular-clock estimates our genus split with other primates around 23 million years ago (Schneider et al., 2001), which means that we share a common ancestor with other primates. We share some of our decision-making processes (e.g., the framing effect) with the other animals.

One study the sought to investigate the framing effect in other primates used 40 bonobos (Pan paniscus) and chimpanzees (Pan trogladytes) (Krupenye et al., 2015). The apes were required to make choices between a positively framed option that provided a preferred food item (fruit) and a negatively framed option with a different food item (peanuts). The apes completed 5 sessions of 12 trials on separate days. Both the bonobos and the chimpanzees choose the positively framed option more than the negatively framed option demonstrating that they were susceptible to the framing effect. Furthermore, male apes were more susceptible then female apes to the framing effect.

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Capuchin monkeys (Cebus appella) have also shown the framing effect in several different studies (Chen et al., 2017; Lakshminarayanan et al., 2011). In their natural environments capuchins live in complex environments, they are socially sophisticated primates whose native environment requires careful management of their scarce resources. The study by Lakshminarayanan et al., (2011) found that capuchins are able to learn how to trade tokens for food. When trading tokens they are susceptible to framing effect for positively and negatively framed choices.

The results of the capuchin, bonobo and chimpanzee studies suggest that the mechanisms that drive the framing effect is evolutionarily ancient. Some of our ‘human’ economic biases are shared by Noam and the other primates throughout the primate order. These studies highlight the importance of comparative research in understanding the origins of cognitive biases and individual differences in human decision-making. To understand the human brain and decision-making we should complement of research by looking towards our distant relatives.