Status Quo Bias（presentation）

Individual or group presentations will be on the supplementary reading chapters posted in Blackboard. Each individual student or group will chose a topic of interest and put together a 10-15 minute presentation summarizing the chapter, detailing how the information can be used by the individual to enhance personal financial planning, and explaining how the information can be used by financial planners to enhance the work that they do with their clients. More information and guidance will be given in class and posted on Blackboard.

Chapter23 page248-274

Status quo bias

Whosoever desires constant success must change his conduct with the times. — Niccolo Machiavelli (1532)

BIAS DESCRIPTION Bias Name: Status Quo Bias Bias Type: Emotional General Description. Status quo bias, a term coined by William Samuelson and Richard Zeckhauser in 1988,1 is an emotional bias that predisposes people facing an array of choice options to elect whatever option ratifies or extends the existing condition (i.e., the “status quo”) in lieu of alternative options that might bring about change. In other words, status quo bias operates in people who prefer for things to stay relatively the same. The scientific principle of inertia bears a lot of intuitive similarity to status quo bias; it states that a body at rest shall remain at rest unless acted on by an outside force. A simple real-world example illustrates. 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 percent 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 percent of the residents “chose” to pay less.

Technical Description.

Status quo bias refers to the finding that an option is more desirable if it is designated as the “status quo” than when it is not.2 Status quo bias can contribute to the aforementioned inertia principle, but inertia is not as strong as status quo bias. Inertia means that an individual is relatively more reluctant to move away from some state identified as the status quo than from any alternative state not identified as the status quo. People less readily abandon a condition when they’re told, “Things have always been this way.” Status quo bias implies a more intense “anchoring effect.” Status quo bias is often discussed in tandem with other biases, namely endowment bias (see Chapter 13) and loss aversion bias (see Chapter 19). Status quo bias differs from these two in that it does not depend on framing changes in terms of losses and potential gains.3 When loss aversion bias and status quo bias cross paths, it is probable that an investor, choosing between two investment alternatives, will stick to the status quo if it seems less likely to trigger a loss—even if the status quo also guarantees a lower return in the long run. Endowment bias implies that ownership of a piece of property imbues that property with some perceived, intangible added value—even if the property doesn’t really increase the utility or wealth of the owner. By definition, endowment bias favors the status quo—people don’t want to give up their endowments. Loss aversion bias, endowment bias, and status quo bias often combine; and the result is an overall tendency to prefer things to stay as they are, even if the calm comes at a cost.

PRACTICAL APPLICATION

Investors with inherited, concentrated stock positions often exhibit classic status quo bias. Take the case of a hypothetical grandson who hesitates to sell the bank stock he’s inherited from his grandfather. Even though his portfolio is underdiversified and could benefit from such an adjustment, the grandson favors the status quo. A number of motives could be at work here. First, the investor may be unaware of the risk associated with holding an excessively concentrated equity position. He may not foresee that if the stock tumbles, he will suffer a significant decrease in wealth. Second, the grandson may experience a personal attachment to the stock, which carries an emotional connection to a previous generation. Third, he may hesitate to sell because of his aversion to the tax consequences, fees/commissions, or other transaction costs associated with unloading the stock. The advice section of this chapter reviews some strategies for dealing with each of these potential objections—all of which could contribute to status-quo-biased behavior. Implications for Investors.

Box 23.1 reviews four investment mistakes that can stem from status quo bias.

RESEARCH REVIEW

Samuelson and Zeckhauser’s paper, “Status Quo Bias in Decision Making,”4 provides an excellent practical application of status quo bias. It examined a study in which subjects were told that they had each just inherited a large sum of money from an uncle and could choose to invest the money in any one of four possible portfolios. Each portfolio offered a different level of risk and a different rate of return. The scenario was repeated twice; in the first trial, subjects were given only the aforementioned information, with no indication of how the conferring uncle might have invested the money himself. In the second trial, the subjects were informed that the uncle, prior to his death, had invested the sum in a moderate-risk portfolio—one of the four options available to the subjects at present. As you might expect, the moderate-risk portfolio proved far more popular in the second trial, when it was designated as the status quo, than in the first trial, when all options were equally “new.” This study reinforced the idea that investors tend to prefer upholding the present status. Advisors need to recognize this phenomenon and target their advice accordingly. Status quo bias is strong and, since it is an emotional bias, a lot of skill must be exercised in order to guide clients away from it.

1. Status quo bias can cause investors, by taking no action, to hold investments inappropriate to their own risk/return profiles. This can mean that investors take excessive risks or invest too conservatively.

2. Status quo bias can combine with loss aversion bias. In this scenario, an investor facing an opportunity to reallocate or alter an investment position may choose, instead, to maintain the status quo because the status quo offers the investor a lower probability of realizing a loss. This will be true even if, in the long run, the investor could achieve a higher return by electing an alternative path.

3. Status quo bias causes investors to hold securities with which they feel familiar or of

which they are emotionally fond. This behavior can compromise financial goals, however, because a subjective comfort level with a security may not justify holding onto it despite poor performance.

4. Status quo bias can cause investors to hold securities, either inherited or purchased, because of an aversion to transaction costs associated with selling. This behavior can be hazardous to one’s wealth because a commission or a tax is frequently a small price to pay for exiting a poorly performing investment or for properly allocating a portfolio.

BOX 23.1 Status Quo Bias: Behaviors That Can Cause Investment Mistakes

DIAGNOSTIC TESTING

These questions are designed to detect signs of cognitive errors stemming from status quo bias. To complete the test, select the answer choice that best characterizes your response to each item.

Status Quo Bias Test

Question 1: Which of the following would you choose? a. A 100 percent chance of winning $10,000.

b. An 80 percent chance of winning $13,000, with a 20 percent chance of winning nothing.

Question 2: Your investment portfolio contains a certain high-quality corporate bond. The bond has been providing income for you, and you are happy with it. Your financial advisor analyzes your bond holdings and recommends that you replace the corporate bond with a municipal bond of comparable quality, estimating that you will obtain a better return after capital gains taxes and fees. You aren’t familiar with this municipal bond. What is your most likely response?

a. I will sell the corporate and purchase the municipal bond.

b. I will keep things as they are.

Question 3: Suppose that you have inherited a fully liquid investment in a South African gold mine from your eccentric Uncle Jim. You discuss the asset with your financial advisor, and she concludes that your portfolio already contains enough gold and commodities. More important, Uncle Jim’s bequest isn’t a diversified asset. Your advisor recommends selling it. What is your most likely course of action?

a. I will sell, as recommended by my financial advisor.

b. I will hold onto the gold mine interest, because I don’t like to sell or modify things that people pass away and leave to me.

Test Results Analysis

Question 1: This question presents a classic intersection of status quo bias and loss aversion bias; most people exhibit a little of each and, accordingly, select “a.” The unbiased option is “b,” which has a higher expected value than “a.”

Question 2: People who select “b” are likelier to suffer from status quo bias than people who select “a.” Option “a” probably offers higher returns, but option “b” is, alas, the status quo.

Question 3. In this situation, most people would behave as depicted in “b,” even when lacking any cogent rationale for holding the asset. Option “b” suggests status quo bias; “a” does not.

ADVICE

This section offers advice on each of the specific investor errors outlined in Box 23.1.

Holding Inappropriate Assets. Education is essential to overcoming this aspect of status quo bias. As previously noted, status quo bias is exceptionally strong and difficult to overcome. Demonstrating the downside risks associated with holding inappropriate assets is often an effective tactic and may motivate people to change their behavior. Another persuasive approach is to demonstrate, based on a single stock position, what could happen to overall wealth levels if the market goes south and then to explicitly link wealth changes with probable lifestyle changes.

Status Quo Bias and Loss Aversion Bias. Doing nothing is much easier than making a decision. This is especially true when a decision might bring about emotional pain, for example, the decision to sell a losing investment may register the impact of a loss. Sometimes, however, inaction can compromise long-run returns. When clients hesitate to implement changes, advisors should carefully analyze whether adhering to the status quo will affect attainment of financial goals. If you discover that your client’s biased behavior will indeed impact his or her wealth down the road, then education is critical. Explain to clients the common cognitive and emotional oversights they may be committing and demonstrate the benefits of decisive action.

Status Quo Bias and Emotional Attachment. Emotions are perhaps the least legitimate concerns in asset management. When financial goals are in jeopardy, it can be too risky to sit back and adhere to an affective whim. Advisors need to demonstrate how emotions need to be managed. “Emotional intelligence,” a well-publicized topic in popular psychology, offers many insights to this end. Do a little reading, and you may find yourself better equipped to help your clients work through their emotional attachments.

Status Quo Bias and Fear of Transaction Costs. Taxes and fees are legitimate concerns when it comes to altering an allocation status quo. However, more often than not, these concerns pale in comparison to the other potential implications of holding, or exiting, a poorly performing security. If you are an advisor, run through some financial calculations with your client. Then, be ready to be persuasive in communicating the advantages of diversification and proper asset allocation.