Summit Financial Resources, Inc.
Cohen’s Corner
A Discussion on Behavioral Finance
By Daniel Cohen
Volume 8
Status Quo
If investors were perfectly
rational, bias-free, utilitymaximizing beings (as they
are assumed to be in
traditional finance theory),
they would always hold
optimal portfolios. Armed
with perfect information
and unburdened by time and cognitive limitations, the
traditional finance investor would continuously analyze
the entire opportunity set of investments available in
the marketplace. As market developments unfolded,
they would revise their expectations for all securities
and shift their holdings accordingly to arrive at the
optimal portfolio - one that maximizes expected utility
for a given level of risk.
to be available. In the context of both security selection
and asset allocation, investors often tend to prefer
taking no action rather than making a change. This
phenomenon is an emotional bias known in behavioral
finance as “status quo.”
As discussed in the first installment of this series
(“Behavioral Finance: An Introduction”), the tenets of
traditional finance are grossly unrealistic; actual investor
behavior deviates consistently and dramatically from
that prescribed by this school of thought.
The tendency for investors to maintain the status quo is
thought to originate from two main sources. The first is
inertia. Making changes can require a great deal of
effort. Faced with time and cognitive constraints,
investors choose to maintain their preexisting
positioning rather than expend the effort required to
research new securities, explore the pros and cons of
different asset allocation options, etc. The second main
reason investors are thought to gravitate towards the
status quo is to avoid the anguish associated with
making a potentially bad decision (this is known as
regret aversion bias and will be explored in a future
issue of Cohen’s Corner). Even though there may be
significant opportunity costs associated with
maintaining the status quo, investors often select this
option because errors of omission are much easier for
individuals to deal with emotionally than errors of
commission.
COHEN’S CORNER
The bias explored in this issue specifically challenges
two fundamental principles of traditional finance: (1)
investors continuously revise expectations of risk and
return for all securities, and (2) investors regularly
update holdings and allocations to maintain a utilitymaximizing portfolio.
If these assumptions were valid, one would expect to
observe some turnover (a measure of how frequently
assets are bought and sold) in investors’ portfolios. This
is because as investor preferences and the risk/return
profiles of individual securities are revised over time,
some holdings that once belonged in an investor’s
optimal portfolio would no longer be appropriate and
would need to be sold. Likewise, some securities that
once did not warrant inclusion in an investor’s optimal
portfolio would become appropriate holdings and would
need to be purchased. Thus, if investors were perfectly
rational and took steps to maintain optimal portfolios at
all times, we would expect to see some turnover in their
portfolios.
Actual investor behavior runs in contrast with the
behavior predicted by traditional finance. Investors
have often been shown to have a pronounced aversion
to making portfolio changes (thereby exhibiting very low
turnover), even though superior alternatives are likely
Status Quo Explained
Status quo comes from the Latin phrase “in statu quo,”
which literally translates to “in the state in which.” In
behavioral finance, status quo represents investors’
tendency to do nothing, rather than make adjustments
to their individual holdings or asset allocation. Status
quo also speaks to investor behavior in situations where
a preexisting or default choice is already in place.
Investors will usually let the default choice stand rather
than choose an alternative.
The term “status quo bias” was first coined by William
Samuelson and Richard Zeckhauser in their 1988 study
“Status Quo Bias in Decision Making.” In this study, a
questionnaire containing a set of multiple-choice
questions was presented to participants. In one version
of the questionnaire, one of the choices in each
question was labeled as the status quo. In the other
version, each choice was presented neutrally, with no
associated label. When a choice was presented as the
status quo, there was a significantly greater likelihood
that it was chosen by the subjects. Samuelson and
Zeckhauser’s concluding commentary elegantly captures
how status quo bias runs in contrast with traditional
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finance theory and presents additional potential
impetuses for the bias:
Consequences of Status Quo
Status quo bias can lead investors to hold portfolios that
are unsuitable. For example, consider a young investor
whose portfolio is heavily tilted towards stocks. If the
status quo is maintained and he doesn’t adjust his asset
allocation as he ages he may wind up being exposed to
inappropriate levels of risk.
“The finding that individuals exhibit significant status quo
bias in relatively simple hypothetical decision tasks
challenges the presumption (held implicitly by many
economists) that the rational choice model provides a valid
descriptive model for all economic behavior … Despite a
desire to weight all options evenhandedly, a decision maker
in the real world may have a considerable commitment to,
or psychological investment in, the status quo option. The
individual may retain the status quo out of convenience,
habit or intertie, policy (company or government) or custom,
because of fear or innate conservatism, or through simple
rationalization.”
Additionally, the investor who is prone to status quo
bias will fail to explore other opportunities and may
hold securities with poor prospects, even when more
attractive securities are available.
Detection of Status Quo
Several additional studies affirm the existence of status
quo bias and illustrate its pervasiveness. For example, in
their 2004 study “How Do Household Portfolio Shares
Vary with Age,” John Ameriks and Stephen Zeldes
tracked the quarterly account balances and
contributions over a thirteen-year period for 16,000
403(b) participants at TIAA-CREF. The authors’
conclusions are profound:
As an emotional bias, status quo is difficult for investors
to detect. Working with a financial advisor is a good
solution. The advisor can utilize a questionnaire to
screen for status quo bias. One question that helps
uncover the bias is: “How would you describe the
frequency of your trading?” Investors who answer that
they rarely, if ever, make trades are more likely to be
afflicted by status quo bias. The advisor can then engage
the client in discussion, digging deeper into the
motivation for his portfolio design, to determine if they
are indeed victims of the bias.
“The vast majority of households make few or no changes
over time to their portfolio allocations … 47 percent of
individuals made no changes in flow allocations over the
entire ten-year period, and another 21 percent made only
one change. Roughly 73 percent … made no change in asset
allocations over the entire ten-year period and another 14
percent made only one change. A full 44 percent of the
population made no changes whatsoever to either their flow
or asset allocations over the ten-year period …”
Dealing with Status Quo
Status quo bias can be difficult to overcome, particularly
without help. Just as financial advisors can help uncover
the presence of status quo, they can also help manage
and mitigate the impact of the bias. To this end,
education and open dialogue between client and
advisor is critical. If you are afflicted by status quo, your
advisor should explain how changing your allocation can
enhance the expected risk/return profile of the portfolio
and how this can lead to a greater probability of
achieving your financial goals.
One additional noteworthy study is “The Power of
Suggestion: Inertia in 401(k) Participation and Savings
Behavior” by Brigitte Madrian and Dennis Shea. The
study compared 401(k) plan participant behavior at a
large U.S. corporation before and after the company
began automatically enrolling employees in the plan.
The default contribution rate for automatically
enrolled individuals was a meager 3%, and the default
investment selection was a 100% allocation to a
money market fund. This contribution rate is
inefficient from a tax perspective (participants had
the option to invest up to 15% of their pretax
earnings in the plan) and the allocation is overly
conservative for most plan participants. Nonetheless,
the authors found that automatically enrolled
participants tended to stick with the defaults:
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Coming up in Cohen’s Corner:
Next Month’s Bias: Anchoring and Adjustment
This is the eighth installment in a multi-part series. To access
this piece as well as other volumes, go to
www.SummitFinancial.com/CohensCorner
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“… A substantial fraction of 401(k) participants hired under
automatic enrollment retain both the default contribution
rate and fund allocation even though few employees hired
before automatic enrollment picked this particular outcome.
This ‘default’ behavior appears to result from participant
inertia and from employee perceptions of the default as
investment advice …”
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