Behavioral biases and retirement assets allocation of corporate pension plans

Abstract

Purpose The purpose of this paper is to investigate the existence of behavioral biases, disposition effect and house money effect in investment decisions of defined benefit pension funds. It investigates the determinants of portfolios by examining whether pensions display risk seeking or risk aversion behavior in reaction to prior gains and losses. Design/methodology/approach The first research question is to examine the impact of prior period’s return and αs on existing portfolio allocation in equity, debt, real estate and other assets. In order to test this relationship, four separate regressions are estimated using the pooled data. Regression helps in examining the relationship between prior gains with current allocation in four categories of assets of varying degrees of riskiness (stocks, debt, real estate and other assets). In order to investigate the second research question on whether pension funds increase (decrease) their investments in risky (safer) assets due to prior gains and αs, the four variables representing the changes in portfolio allocation for each asset class over one period are employed. These changes in allocation are regressed against the prior year’s actual return, expected return, αs and a set of control variables. Findings The results suggest significant negative (positive) relationship between prior positive returns and αs with portfolio allocation in risky (safer) assets. Also, there is an increased (decreased) investment in safer (risky) assets following prior period’s positive returns and αs. The findings confirm the existence of disposition effect, while there is no evidence of house money effect. Originality/value The portfolio allocation of pension plans provides unique setting to investigate the relevance of behavioral finance and examine the role of psychological biases on risk taking. This study attempts to contribute to the literature by empirically investigating whether the tenets of behavioral finance are relevant in defined benefit pension fund’s portfolio allocation decisions. Specifically, it focuses on the determinants of portfolio choices by directly investigating pension funds’ reaction to prior period’s actual as well as risk adjusted return (or αs – the difference between the actual and expected return).