Change can be difficult to accept, and even more difficult to choose over the familiar. In fact, some people forego beneficial change for the comfort of continuing what they know. Such behavior is caused by the status quo bias, which can have a significant influence on our decisions in life and finance. Chief Operations Officer Miranda Carr explains the status quo bias.

NOTE: This podcast was recorded prior to the rebrand of Finworx as Lirio Finance.

stitcher-podcast-small1

Transcript

(* Indicates language updated to reflect current brand and position.)

I’m Miranda Carr, Chief Operations Officer at Lirio,* and I want to talk about the status quo bias. I think all of us are probably very familiar with this bias, but I want to discuss, not only how it relates to life, but how it relates to wealth management and investing.

The status quo bias is an emotional bias that predisposes people to continue existing conditions, rather than alternative behaviors that might bring about change. It was originally conceived by William Samuelson and Richard Zeckhauser in 1988, and it just captures the reality that people don’t really like change.

Let’s run through a few quick examples of the status quo bias that people may encounter on a daily basis:

  • Have you or someone you know ever gotten gym membership, and then after a few months, stopped going? Many people continue to keep their gym membership active even if they don’t use it, because it becomes the new status quo, and it takes effort to make a change.
  • Now, suppose you get an advertisement in the mail that a new provider is offering cable in your neighborhood for a lower price, or maybe a wireless carrier has cut prices for cell phone plans, and you can get the same service on a new carrier for a cheaper price. Economic theory would suggest that consumers would do a cost benefit analysis and determine if the new cable provider or wireless carrier makes economic sense, but often times people don’t make it that far, because people naturally resist change. You’re more likely to just toss the advertisement in the trash without going through the comparison effort.
  • What about this… Why do you see people filling up at a gas station when there is another gas station across the street whose prices are a couple cents lower? Sure, it could have something to do with loyalty, and there may be some other rational factors at play, but often times, people act a certain way simply because they don’t like changing their routine.
  • When you are creating an account to buy something online, what do you do when you get to the box at the bottom of the page that asks if they can send you an email about future deals or events? Many people will leave the box as the default selection, so if the website phrased the statement as “Click here if you would not like to be emailed,” instead of “Click here to be emailed,” the website is likely to get more people added to their email distribution list.

“Things have always been this way,” or “I’ve been doing it this way for 30 years,” are common phrases that provide insight into what motivates this behavior and drives these types of decisions, or sometimes, non-decisions. These terms and behaviors are evident in everyday life, but can have long-term consequences when the status quo affects financial decisions and potential portfolio changes.

Investors who have status quo bias tend to do nothing instead of making a change. These clients prefer the comfort of keeping things the same, even when making a change would be beneficial. While seemingly everyone has at least a very small resistance to change, people with a low risk tolerance and emotional biases tend to be the most susceptible to this bias. At its most basic form, the status quo bias is easily understandable. Someone has gotten so used to a certain way of life that changing those habits is very difficult.

From a financial advisor’s perspective, clients with this bias can have inappropriate portfolios that can open them up to even greater risks down the road. For example, think about a client who began investing at the age of 25 when they were single, had no children, and displayed a high willingness to take risk. This client could have been in a portfolio that was heavily weighted to equities, with portfolio weights as high as 80-100%.

Fast forward twenty-five years. The client has gotten married, had children, and his or her willingness to take risk has decreased slightly. However, they are reluctant to change their portfolio. Say their portfolio has had returns of nearly 10% per year and has served them well. But if there were a drawdown tomorrow or something were to happen, the client could be susceptible to poor financial decisions as their portfolio loses more value than they are comfortable with. This is because that client has been reluctant to change their investment strategy, despite major life changes and risk tolerance.

There are numerous examples of the status quo bias in the real world as well. In his book “Behavioral Finance and Wealth Management,” Michael Pompian discusses the following example:

“In the early 1990s, the states of New Jersey and Pennsylvania reformed their insurance laws and offered new programs. Residents had the opportunity to select one of two automotive insurance packages: (1) a slightly more expensive option that granted policyholders extensive rights to sue one another following an accident, and (2) a less expensive option with more restricted litigation rights. Each insurance plan had a roughly equivalent expected monetary value. In New Jersey, however, the more expensive plan was instituted as the default, and 70% of citizens “selected” it. In Pennsylvania, the opposite was true – residents would have to opt out of the default, less-expensive option in order to opt into the more expensive option. In the end, 80% of the residents “chose” to pay less.”

Are the citizens of Pennsylvania and New Jersey really that different? Probably not, they simply hesitated to change from the default option. Once given a default, people become anchored to that and will make future decisions based on the current situation. This is the status quo bias in action. In the scenario I just outlined, both options had the same expected payout, so the choice between the two options should have had very little impact on the end result for the individuals.

But what happens when there are greater consequences between decisions?

Organ donation is an area of healthcare that has received much attention regarding the status quo bias. The status quo bias is often discussed when talking about “opt-in“ vs. “opt-out” because, as discussed in the last example, it is widely documented that people are more likely to “choose” an option if one must “opt out” from it. In Europe, some countries have an “opt-in” policy when it comes to organ donation, while others have an “opt-out” model, and the difference in results is staggering.

Some countries, like the United Kingdom and Germany have an opt-in policy for organ donation, meaning that the person has to specifically make a decision if they want to be an organ donor. Less than 20% of people in these two countries are organ donors. On the other hand, countries such as Austria and Belgium automatically enroll people for organ donation, so they have to take action if they do not want to be an organ donor. In these countries, the organ donor participation rate exceeds 98%!

While there certainly could be some other factors at play, it seems clear that whether or not something is set as a default option has a major impact on how people make decisions. It is as simple as checking or unchecking a box, yet overwhelmingly, people tend to stick with the default choice.

Switching back to finance, Behavioral Economist Richard Thaler provides us with a fascinating case study on status quo bias, when a decision between multiple choices does not have the same expected value. He attempted to use behavioral economics to help individuals save a higher percentage of their paychecks. The idea, called “Save More Tomorrow,” presented people with the option of deciding now to increase their savings rate later, specifically, when they get their next raise.

With the initial understanding that pay might be tight at the present time, the prospect of increasing their savings rate and receiving more in their paycheck incentivizes an increased savings rate. This helps avoid loss aversion. By asking them to commit to the increase in the future, their bias against changing present outcomes was mitigated.

When he first hatched this plan, there were no takers. No one called Thaler about the plan and it was largely forgotten. However, one financial services consultant, Brian Tarbox, eventually adopted the idea. When Tarbox had initially proposed that employees increase their savings rate by five percentage points, most employees did not believe that was feasible. The employees that were unwilling to adopt this plan were then presented with the Save More Tomorrow plan.

Tarbox suggested that they agree to raise their savings rate by three percentage points the next time they got a raise, and continue to do so for each raise after that, up to four annual raises. When presented with this plan, 78% of employees decided to participate! Why did so many people choose to participate? Even for people who have the status quo bias and are reluctant to make change, it is much easier to commit to a change “sometime in the future” than it is to make a change now.

After three and a half years, and four annual raises, the Save More Tomorrow participants had increased their savings rate from 3.5% to 13.6%! The few employees who took Tarbox’s initial advice of increasing their savings rate five percentage points had their savings rate stuck at the initial increase for the duration of the study.

As inertia and the status quo set in, people are unlikely to change their decisions. This is evident in the savings rate for those who initially increased their rate by five percentage points. They initially saw the benefit in the change, but once they became used to this static savings rate, the status quo set in and their ending savings rate was nearly five percentage points less than those who participated in the Save More Tomorrow plan.

Those who declined the SMT plan actually saw their savings rate decline throughout the duration of the study, which isn’t surprising. One possible explanation is that these employees maintained a similar dollar amount of savings, but received raises that increased their pay, thus lowering their savings rate overall. This can be very costly for an individual in the long run.

Think about two completely identical employees, but one participated in the Save More Tomorrow plan and one did not. They both begin making $50,000 per year and receive a $5,000 per year raise, but one ends with a savings rate of 13.6% and the other with a rate of 6.2%. At the end of the fifth year, the employee who participated in the Save More Tomorrow plan had saved an additional $8,440, while also increasing their take-home pay by more than 5% per year.

The ending balance of their savings account after just five years was $28,025 compared to $19,585. If this additional $8,440 was invested in an account that earned 4% interest, the ending balance after 25 years would be $22,500! This means that the opportunity cost of avoiding the Save More Tomorrow plan could be more than $20,000 over time!

The status quo bias is often accompanied by other biases that can lend themselves to more problematic outcomes for clients if they are allowed to continue. When the status quo bias is combined with loss aversion, it is possible that an investor could maintain a portfolio that could trigger large losses and have a lower expected return just because it is the status quo.

Loss aversion, endowment, and the status quo bias are commonly seen together, and the result is an investor who is extremely reluctant to change, no matter the cost. So how can an advisor help an investor overcome the status quo bias? This bias is an emotional bias, so it tends to be harder to correct than cognitive biases, which often times, can be corrected through education.

The way to correct the bias is to very clearly point out the flaw in the investor’s logic, without being insulting. For example, in the example where an investor is holding a portfolio that may be too aggressive for their risk tolerance, it may be useful to show them how their portfolio would have performed during historical market drawdowns, and compare it to a portfolio that is more appropriate for them.

Depending on the investor’s persona, it may be even more effective if you show them the impact that the loss would have in dollar terms, not just a percentage loss. It may also be effective to point out the flaw in their thinking by asking them, “What would you do if you were already invested in the more conservative portfolio. Would you make a change to the more aggressive portfolio?” It is important, however, to keep in mind that being resistant to change is often a deeply rooted part of a person’s personality, so it may be a very difficult task to overcome this bias.

Investors with the status quo bias are likely to have lots of excuses in order to avoid making a change, so it is important to be prepared. For investors, one of the most common excuses is the investor’s desire to avoid transaction costs. Trading isn’t usually free, and selling a security is likely to create a taxable event.

While both of these are true and should be evaluated on a case by case basis, the cost of holding an inappropriate portfolio has the potential to have a much higher long-term cost than a one-time trading cost or taxable event. It may be useful to include taxes and transaction costs when running scenarios to show an investor that, even after transaction costs, it still makes sense to make a change.

The status quo bias can certainly be a problem for investors when they fail to make needed changes, but is there a way to harness the bias in order to improve outcomes? As discussed in earlier examples, some European countries use the status quo bias in order to increase organ donation, and the bias can also be used to help people save more of their paycheck. As a financial advisor, what if you also used the bias to help nudge investors in the right direction?

Suppose, when presenting a client with a choice of investments, you labeled the most appropriate investment for them as the default choice. Or, when setting up a 401k plan, what if you set it up for automatic enrollment so that employees have to opt out if they don’t want to save money for retirement? These are just two examples of nudges that can be used to help an investor make better financial decisions. Be careful here, though. Leading investors to make a specific decision by setting default options may not always be viewed favorably, even if you are acting in the client’s best interest. Mindfully setting defaults, though, and discussing all options could lead to better outcomes and higher satisfaction levels among your clients.

The status quo bias is a fascinating bias that has major implications on how people make decisions every day. If you have questions about the status quo bias or want to share other examples, tweet us @lirio_llc, #LirioFinance.*

For additional podcasts, subscribe on iTunes.
Find Lirio Finance online at Lirio.co/Finance. Follow us on TwitterLinkedIn, and Facebook.*

 

* Updated to reflect new Lirio Finance branding. Finworx is now Lirio Finance, and Miranda Carr is now Chief Operations Officer.

The thoughts and opinions expressed in this podcast are solely those of the person speaking.

The opinions expressed are as of the date of this podcast and may change as subsequent conditions vary. This podcast is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this podcast is at the sole discretion of the listener.

© Lirio, LLC