Why People Lose Their Life Savings

You've probably heard it again and again: diversify your investments. So why do people — including thousands of Enron employees — get stuck with unbalanced 401(k) plans that become worthless when their company's stock craters?

For Enron employees who say they were misled by management about the health of the company, the short answer is that they never suspected a company in the top 10 of the Fortune 500, as Enron was last year, could crash and burn so quickly and completely.

But behavioral economists — a growing group in the ranks of academia — have a longer answer. They say employees, contrary to the assumptions of most economists, rarely think logically about their portfolios. Indeed, precisely because of the psychological attachment workers have for their employer, they find it difficult to make objective decisions about the company stock.

"You start thinking about all the good things you know about the company," says Terrence Odean, a professor at the University of California at Berkeley. "The inside view is one of the things that hurts people."

Who Says People Act Rationally?

This so-called "inside view" — a term popularized by Princeton University psychologist Daniel Kahneman — is just one of many phenomena behavioral economists have observed over the years that cast doubt on classical economic thinking, in which people are viewed as self-interested, rational thinkers shrewdly calculating the bottom line.

By contrast, behaviorists like to paint a picture of individuals full of quirks leading them to act in ways that don't make financial sense. The best-known of the breed is Richard Thaler of the University of Chicago, who for years has noted "anomalies" in people's economic decisions.

Take a Behavioral Economics Quiz

An early example that helped shape Thaler's thinking: a friend who acknowledged he mowed his own lawn to save $10, but said he would never mow a neighbor's lawn to earn the same amount of money.

As its name indicates, behavioral economics has been heavily influenced by the insights of psychologists — especially Kahneman and his late colleague, Amos Tversky, who argued that people dislike losing money more than they enjoy gaining it. Thus investors hate to sell on the way down — a familiar story in this time of stock market deflation.

Another counter-intuitive insight: consumers can be thrown off by having too many choices. Recently, Columbia University business professor Sheena Iyengar and Stanford University psychology professor Mark Lepper set up a grocery store experiment featuring jam booths that had either 6 or 24 flavors on display, to see which one shoppers preferred.

The result? More shoppers stopped at the booth with 24 flavors — but those stopping at the 6-flavor booth were 10 times more likely to pick out a single jam and actually buy it.

The Power of Suggestion

In light of the Enron debacle, with former company employees tearfully detailing their losses in front of Congress and television cameras, understanding the way people handle their money seems all the more important.

For instance, a study by Thaler and Shlomo Benartzi of UCLA shows that employee decisions about retirement plans, instead of being carefully calculated, simply tend to closely mimic the choices presented to them by their employers.

Surveying employees of TWA and the University of California, Thaler and Benartzi observed that workers with the choice of one stock fund and one bond fund in their pension plans tend to invest about half of their money in each — rather than independently assessing whether they want to invest more in stocks, which are riskier but promise greater returns, or take a more cautious approach.

Similarly, TWA employees with the choice of five stock funds and one bond fund put roughly 75 percent of their money in stocks, and University of California employees offered one stock fund and four bond funds put just 34 percent of their money in stocks.

A related phenomenon, claims Benartzi, is that when companies fill 401(k) plans with their own stock, employees will do the same. At Coca-Cola, where more than 80 percent of 401(k) assets are in company stock, employees sank a whopping 76 percent of their own voluntary 401(k) contributions into shares of the company as well.

"Employees interpret the allocation of the employer's contributions as implicit investment advice," writes Benartzi in a 2001 paper.

Benartzi and Thaler both declined to comment about Enron for this piece, but Benartzi believes his recent research can be applied to some of the issues faced by Enron employees. That includes another study Benartzi and Thaler performed, in which they argue that too many pension-plan options only serve to confuse workers.

"There is a presumption that adding more choices will make consumers better off, and surely not worse off," write Benartzi and Thaler. In reality, they claim, "whatever gains there are to be had from giving investors the opportunity to choose their own portfolios, they are likely to reach a near maximum with a small number of options."

By extension, some Enron employees — faced with 20 different 401(k) options to choose from, according to company literature — may have frozen up like grocery shoppers looking at dozens of flavors of jam, and simply allowed themselves to own retirement plans loaded with shares of plummeting company stock.

Don’t Worry About Beating the Market

In Washington, the current controversy has prompted President Bush and congressional Democrats to call for a variety of 401(k) plan reforms.

But Odean, for one, points out that employees can always exercise common sense on their own. For starters, they would do well to treat a pension plan differently than other investments, and not worry so much about making sure it beats the market.

Your pension, after all, is intended to be there when you retire.

"Diversifying pretty much ensures you won't get the best possible outcome," says Odean, "but it also guarantees you won't get the worst possible outcome."