2.

A brief review on Target-driven investing: Optimal investment strategies in

defined contribution pension plans under loss aversion

Keywords:
Defined contribution pension plan
Investment strategy
Lifestyle strategy
Loss aversion
Target replacement ratio
Target-driven investing
Threshold strategy
Portfolio insurance
Dynamic programming
Background
This is a brief review on the paper entitled Target-driven investing: Optimal
investment strategies in defined contribution pension plans under loss aversion by
David Blake, Douglas Wright and Yumeng Zhang, which is published in the
Journal of Economic Dynamics & Control in 2012 (Article in press. Available
online in August).
Originality
The paper aims to apply the concept of loss aversion proposed by Kahneman and
Tversky (1979), which forms a part of the framework of prospect theory (PT), to
show that the optimal investment strategy for members of defined-contribution
(DC) plan is a target-driven threshold strategy1. The traditional expected utility
model, on the other hand, only considers the risk aversion in respect of the
terminal fund value at retirement.
1

The optimal dynamic asset allocation strategy within the framework of PT is target-driven,
meaning that the weight in risky assets such as equity will depends on whether the target is met.
The weight in risky assets is increased if the accumulating fund in a DC plan is below the relevant
interim target and is decreased if the fund is close to the target. Such decision is due to loss
aversion in which the member is risk seeking in the domain of losses, and risk averse in the
domain of gains. If the accumulating fund is close to the interim target, the member will keep the
lowest equity weighting so as to minimize the risk of loss. However, if the accumulating fund is
above the interim target, the weight in risky assets will increase again because the effect of
portfolio insurance starts to kick in.

The proposed model in the paper differs from the existing literature mainly in
three aspects below which are relevant to and extend the present knowledge:
(i) Loss aversion: that is, the use of a PT function to determine the
optimal asset allocation model in a DC plan.
(ii) Stochastic labour income: instead of using a deterministic model for
labour income, in the paper a stochastic model is used.
(iii) Choice of investment targets: the interim targets are path-dependent
rather than assuming fixed targets.
Research methodology and evidence
In the paper a two-asset discrete-time model with a constant investment
opportunity is put forth2. As regards the target, the final target of the retirement
fund is compiled from the expected income at retirement, the price of a life
annuity at the age 65, and the target replacement ratio of two-thirds of income at
retirement. The interim target at each age is discounted from the final target.
It is opined that by using the randomly simulating numerous possible outcomes, a
real world situation can be reproduced as realistically as possible. This is an
advantage of stochastic model over the deterministic model. The conclusion is
logical and sound.
Simulation method is employed to determine the optimal asset allocation for each
year of the plan. The authors generate 10,000 scenarios over the period up to
retirement, based on the variation in disturbances in both risky asset returns and
labour income3.
2

The two underlying assets for the pension fund are a risk-free asset (a bond fund) and a risky
asset (an equity fund). The real return to the risk-free asset is fixed, while the disturbance of the
risky asset is determined by a series of independent and identically distributed standard normal
random variables. The labour income also has a built-in stochastic process. As regards the
pension fund accumulation, it depends on the fixed contribution rate and the exponential function
of the return from assets.
3

The outcome is that the mean optimal equity allocation from the target-driven strategy depicts a
more gradual switching from mainly equities at the younger age to mainly bonds nearer to the
retirement age. Even at the retirement age, the portfolio is comprised of around 40% of equities.
On the other hand, for a conventional lifestyle strategy, the equity weighting will reduce from
100% to 0% in a linear manner in the 5-10 years prior to retirement. Moreover, there is nearly
2

Theoretical implications
The paper finds that:
(i)
the optimal investment strategy under loss aversion is consistent
with a threshold strategy.
(ii)
When the switch to a more conservative asset allocation strategy is
implemented at lower current fund values and at a lower age, the higher is
the loss aversion ratio.
(iii) The effect of higher risk aversion in the domain of gains leads to an
earlier switch out of equities, a lower mean replacement ratio, and a lower
expected shortfall. On the other hand, the effect of lower risk aversion in
the domain of losses leads to a later switch out of equities, a higher mean
replacement ratio, and a higher expected shortfall.
(iv) Loss-averse members adopt a more conservative asset allocation
strategy as compared with the standard framework of risk aversion.
(v)
The optimal target-driven investment strategy increases the
likelihood of achieving the chosen target as compared with a lifestyle
investment approach.
Areas recommended for further research
(i) the paper attempts to build a model deductively from the axiomatic system of
PT function so as to answer the question of optimal asset allocation. As a
simulation method is employed to generate the result, it is considered that
empirical observations are required to examine the behaviour of DC plan members
in reality. In other words, the predictions and solutions of the model should be
subject to test to see whether the target-driven threshold strategy can be
falsified4.
75% for a target-driven strategy to meet the target replace ratio, while the lifestyle strategy only
achieves around 59%. The authors also conduct a sensitivity analysis of the baseline model by
altering the loss aversion ratio and the curvature parameters.
4

Under Poppers doctrine of falsificationism.

3

(ii) In the US, an employee is responsible for selecting the types of investments for
the individual account for his retirement plan. The types of investments include
pre-determined mutual funds as well as individual stocks or other securities.
However, in some regions and countries, a member may not be allowed to choose
the equities direct, such as the Mandatory Provident Fund in Hong Kong. This
casts the question as to whether a DC plan member will behave similarly as set out
in the paper.
Nofsinger (2001) finds that to an investor it is more the performance of his pick
relative to the market, rather than the absolute performance of his chosen portfolio,
which has greater influence on the selling behaviour 5.
Therefore, as far as the paper is concerned, it is conjectured that if the
accumulating fund is below the relevant interim target, the member of DC plan
may not feel regret. Very likely he will put the blame on the fund manager rather
than the members own choice of portfolio in the fund plan. He may not adjust the
portfolio as suggested in the paper because so doing is tantamount to admitting
ones own mistake in choosing the fund plan concerned.
Hence, it is suggested that further study should be conducted on the effect of loss
aversion on members of pre-determined mutual funds, to which individual
investors have delegated investment decision, to see whether individual investors
will also show the behaviour of loss aversion. In addition, because of the agency
problem, the study should also cover whether the fund manger will similarly
behave in a loss aversion way.
(iii) Benartzi and Thaler (2004, Section 4) states that the most frequent allocation
between CREF (stocks) and TIAA (mostly bonds) is 50-50, with the average
allocation to stocks below 50%. It is considered that the 50-50 may contribute to
the behaviour of aversion to extremes. That is, if a person is required to make a
decision and the choice may lead to contradictory results, he will tend to select the
median solution which has the advantage of limiting the risk for error 6. Further
Nofsinger has analyzed the trades made between November 1990 and January 1991 by
individual investors in 144 companies listed on the NYSE. He finds that a sharp increase in price
following good macroeconomic indicators do not (or only slightly) encourage selling. On the
other hand, if it is the whole market which goes down, the loss is less badly received. It is only
the regret that an investor has not invested as well as others will an investor more easily sell.
6
Benartzi and Thaler (2002).
5

study on the behaviour of aversion to extremes and its impact on asset allocation
on DC plan is recommended7.
(iv) The annual review of the interim target in the paper is similar to stationary
replication(Loewenstein 1999). It is doubtful that a DC member will not learn
from the frequent annual review of interim target and continue to behave in a loss
aversion manner under a similar and repetitive circumstance 8. It is recommended
that further study should be conducted to figure out whether the stationary
replication has any effects on the asset allocation during the annual review of the
interim target.
(v) Grinblatt and Keloharju (2000) show in a statistically study on the behavior of
investors in the Finnish market that individual investors find it difficult to sell
securities which are losing relative to the market. However, the difficulty is time
sensitive. After a month, the impact of the underperformance of the securities on
these investors compared to the market is no longer significant.
As far as the paper is concerned, will there be any change in the behaviour of loss
aversion if a DC plan member is asked again to indicate their asset allocation one
month after the review of interim target? Further study in this regard is
recommended.
Relevance to the Aims and Scope of the Journal of Economic Dynamics and
Control
According to Elsevier (2012), the journal provides an outlet for publication of
research concerning all theoretical and empirical aspects of economic dynamics
and control as well as the development and use of computational methods in
economics and finance. The paper has used the simulation method to generate
the optimal investment strategy for DC plan members, which is a decision support
system for optimization of allocation to bonds and equities. It is considered that
Samuelson and Zeckhauser (as cited in Benartzi and Thaler, 2004, Note 12) also report that once
the typical Teachers Insurance and Annuity Association College Retirement Equities Fund
(TIAACREF) participant makes an asset allocation decision between stocks and bonds, he will
never change it.
7

That is, whether the behaviour of loss aversion in one-shot game will be similar to that in
repeated-game. Nonetheless, it appears that people do learn from experience. For example,
Camerer et al. (2004) found that the inexperienced New York City cab drivers set a daily income
target and stopped working when the target (or the reference point) was met. On the other hand,
experienced cab drivers displayed the conventional intertemporal substitution of labour and leisure
based on the wage rate rather than the daily income target.
8

the paper adheres to the scope and objectives of the Journal. The references used
are the latest in the field and are relevant to the topic.

End
Number of words: (about 1,000 excluding footnotes)

Reference List
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investment strategies in defined contribution pensions under loss aversion.
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