Status Quo Bias

The physical sciences would say that an object at rest tends to remain at rest. In decision-making, you often choose the option that allows you to remain at rest. In other words, you prefer the status quo to change.

Consider the plight of a small town in Germany. Due to strip mining of lignite nearby, the law required the government to relocate the town. The government offered to relocate the town to a similar valley close by. Government specialists suggested many alternatives for the layout of the new town. However, the townspeople selected the same layout as the old town, even though the old town's layout had evolved over centuries without any rhyme or reason. The people preferred what they were familiar with to the more efficient and more aesthetic plans.

The status quo bias has a strong impact on employees' contribu­tions and asset allocations in their 401(k) retirement plans (or other defined contribution plan). When you first start working for a new company that offers a 401(k) retirement plan, you must decide how much of your own salary to contribute and where to invest the money. In some firms, you are not eligible to contribute until after one year (or more) of employment.

Consider how the status quo bias can affect your decisions. First, if you are not contributing, then you will probably continue to not contribute. This is very costly. Saving for retirement in a defined contribution plan saves on income taxes and allows for tax-deferred growth of the investments. Furthermore, many employers will match your contribution up to a certain point. If you don't contribute, you miss out on this enormously valuable opportunity. The second way status quo bias affects your decisions involves asset allocation. Your status quo bias will cause you to retain the same asset allocation throughout your working years because you tend never to change your investment choices.

This bias is dramatically illustrated by the experience of a Fortune 500 company that recently changed its 401(k) enrollment policy for new employees.3 The company's old policy required employees to wait one year after their initial employment date to be eligible to participate in the 401(k); then they had to fill out the paperwork for the contributions to begin. Each employee decided how much of the contribution was to be invested in the money mar­ket, stocks, or bonds. The new policy allowed employees to be eligible immediately and automatically enrolled them for a 3% contribution into the money market investment. If employees did not want to con­tribute, they had to fill out paperwork to unenroll. Similarly, if an employee wanted a different asset allocation than the 100% money market investment, she had to fill out paperwork to make the change.

Under the old policy, one year after becoming eligible for the 401(k) plan, only 37% of those employees were contributing. The new automatic enrollment policy had its desired effect - the contri­bution rate jumped to 86%. When the old policy was in effect, the status quo bias worked against the employee. Under the new policy, the status quo bias helped the employee save for retirement.

Unfortunately, the new policy had an unintended effect - an asset allocation that was too conservative, a problem also caused by the status quo bias. Since the average age of the employees is in the mid-30s, you would expect the average asset allocation to be tilted toward stocks. Indeed, Figure 4.1 shows that, before the policy change, employees divided their contributions this way: 75% to stocks, 18% to bonds, and 7% to money market investments.

Before Change to Automatic Enrollment

Figure 4.1

Bonds 18%

Money Market 7%

Stocks 75%

After Change to Automatic Enrollment

Bonds 3%

However, the new policy automatically placed 100% of the contribu­tion into the money market investments. Figure 4.1 also shows how this allocation dominated the contributions of the new employees. When the employee chose the allocation, the mix was 75% stocks and 7% money market. But the automatic allocation led to an aver­age contribution rate of 16% stocks and 81% money market.

Using historical investment data, the asset allocation of the old policy contributors leads to an expected average return of over 10% per year. The new policy contributors can expect just over 5%. The difference will mean that the old policy contributors will have more than double the money in their retirement plans than the new policy contributors will have. The new policy is good in that it uses the sta­tus quo bias of employees to get more people contributing to their retirement plans. However, the same bias is causing those employees to invest too conservatively.

The more complicated the decision needed, the more likely you will choose to do nothing. In the investment world, you face the choice of investing in tens of thousands of company stocks, bonds, and mutual funds. Having all of these choices maybe overwhelming. As a result, you often choose to avoid making a change. This problem

Your bias toward the status quo increases as magnifies the asset allocation the number of investment options increases. Problem in 401(k) Plans A

decade   ago,   firms   offered

three or four investment alternatives in the plan. Now, firms offer

dozens - even hundreds - of choices. What do you do? Many people

do nothing - the status quo.

ATTACHMENT BIAS

The attachment bias is similar to the endowment and status quo biases. When you hold and follow a stock for a long period of time, you can get attached to it. This attachment causes you to see the stock through rose-colored glasses. Remember, an investment is not a statement of who you are. Stocks are simply a way to increase your wealth. Increasing your wealth is desirable because it can maintain or improve your lifestyle. Figure 4.2 illustrates how investors often lose sight of this.

Consider the client of a financial advisor friend of mine. After a long and successful career working at Procter & Gamble, he retired with a nest egg of $2.5 million. The only problem was that nearly all of it was invested in Procter & Gamble stock. This man definitely has enough money to live an active life in retirement. Any advisor would suggest that first he should switch to a preservation goal instead of a growth goal, and then he should diversify, diversify, diversify.

The advisor could convince him to allocate only a small portion of the portfolio into safer investments when the stock was trading at over $100 a share. In March of 2000, Procter & Gamble stock plum­meted to $55 a share. His total retirement portfolio fell nearly 40%. This kind of decrease could change your retirement lifestyle! His response to this event was a desire to buy more Procter & Gamble stock while it was down. Attachment bias can be strong!