Working in a business school (the Tepper School at Carnegie Mellon), many of my colleagues are economists (or “financial economists” as many of my finance colleagues are titled). One of the big hurdles we have in communicating is a differing view of the purpose of models. For many economists, models are used to describe behavior. For instance, a model of certain types of incentives may lead to particular outcome behavior. If we see the outcome behavior, this suggests the model is a good one. If an economist does not see the outcome behavior, then there is a puzzle at best, and a bad model at worst.
For an ORer (a word I just made up, because OR person sound stilted), models are almost always prescriptive: they tell you what to do. For that same model, an ORer will, if happy with the model, not worry about whether the outcome behavior is happening. If not, then people are doing things wrong, and should smarten up and follow the OR prescription.
Articles like the one today in the New York Times (subscription required) make me feel happier about the OR approach. People, even reasonably sophisticated people, just don’t seem to make good decisions. The example is drawn from finance, but examples abound:
MANY index funds track the Standard & Poor’s 500, but they differ from one another in one major respect: their fees. You’d think that it would be obvious to investors to pick the fund that charges the least. But you’d be wrong.
In fact, this truth was anything but obvious to a group of elite students. In an elaborate simulation created by several researchers, many students at Harvard and the Wharton School of the University of Pennsylvania failed to select the lowest-cost index fund for their portfolios, even when they were all but spoon-fed the right answer.
In the first simulation, the professors asked 30 undergraduates at Harvard and Wharton, as well as 83 M.B.A. students at Wharton, to allocate a hypothetical $10,000 among four S.& P. 500 index funds that would be held for one year. All four funds invested in the same 500 companies, and matched the index’s allocation for each stock, so the only significant difference in the funds’ returns would come from their fees — their front-end loads, or sales charges, and their management expenses. And because of the way the professors designed the experiment, these four funds had relatively high fees, ranging from 3.09 percent to 5.89 percent.
Each student received copies of the four index funds’ prospectuses, which varied from 26 to 116 pages long. The prospectuses provided detailed descriptions of the funds’ loads and expenses, along with a great deal of other information. To encourage the students to take the exercise seriously, each was paid a small amount — $5 for undergraduates, $20 for M.B.A. students — and was told that one student at each school, picked at random, would receive any profit that the $10,000 portfolio produced over the 12 months.
The rational response, the professors argue, would have been to allocate all the money to the fund with the lowest fees. Yet fewer than 20 percent of either group of students did so. As a result, the hypothetical portfolios built by most of the students paid much higher fees than were necessary: 1.22 percentage points more, on average, among the undergraduates and 1.12 points higher among the M.B.A. students.
The work was done by James J. Choi, an assistant professor of finance at the Yale School of Management; David Laibson, an economics professor at Harvard; and Brigitte C. Madrian, a professor of business and public policy at the Wharton School. A copy is at http://www.som.yale.edu/faculty/jjc83/fees.pdf.
Makes me happy to be prescriptive!