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Trying to make sense of the breadth and complexity of the financial markets can be a Herculean task, one that frustrates even the most seasoned investors. Why, then, do many companies ask their employees to do just that?
They shouldn’t, according to Brigitte Madrian, Aetna Professor of Public Policy and Corporate Management at Harvard’s John F. Kennedy School of Government, and David Laibson, the Robert I. Goldman Professor of Economics.
In a paper published last year, Madrian and Laibson argued that employers should strive to “design institutions that facilitate good choices, rather than assuming that giving people every option under the sun will lead to the right decision.”
The paper, co-authored with James Choi ’98, associate professor of finance at the Yale School of Management, was recently honored with the TIAA-CREF Paul A. Samuelson Award. The annual award recognizes scholarly writing on lifelong financial security.
Understanding why people make bad choices, Laibson said, required an unusual experimental structure. Participants in the study were asked to allocate $10,000 across four S&P 500 index funds, and were paid according to how their investments performed.
For most people, Laibson said, investments are based on two considerations — how funds perform and the suite of services offered by an investment company. In this study, however, researchers were able to eliminate both, the first because index funds — designed to replicate an index set by the S&P — perform nearly identically, the second because the funds were administered by the researchers.
“Once you eliminate those two considerations all that’s left is what we wanted to focus on, and that’s fees,” Laibson said. “Given this experimental design, the ‘right’ answer is unambiguous; it’s the fund with the lowest fees. What we found is that the participants were, in essence, oblivious to fees.”
“This research shows that individuals aren’t using the right types of information in making mutual fund investment decisions. They place too much weight on past returns, and too little weight on potentially important factors like fees," said Madrian. Read more
David Laibson, the Robert I. Goldman Professor of Economics with Brigitte Madrian, Aetna Professor of Public Policy and Corporate Management
Photo Credit: Kris Snibbe
“This research shows that individuals aren’t using the right types of information in making mutual fund investment decisions," said Brigitte Madrian.