Behavioral aspects of the design and marketing of financial products - Security Design Special Issue

Financial Management (Financial Management Association), Summer, 1993 by Hersh Shefrin, Meir Statman

We have described earlier the prospect theory benefits derived by some investors from framing cash flows into separate mental accounts. We turn now to another use of the separation of cash flows into mental accounts, the regulation of consumption over the life cycle.

It is a common observation that some investors follow the rule of "don't dip into capital." They feel free to consume from income, such as labor income or dividends, but not from capital. Such behavior makes no sense in a world where people do not care about the frames or labels of cash flows. In Shefrin and Statman |36~, we investigated the importance of labeling cash flows as income or capital. We suggested that investors prefer income mental accounts that are downside protected. Both dividends and option premium fall into that category.(9)

The importance that some covered call writers attach to labeling option premium as income is evident in the literature provided by the Chicago Board of Options Exchange (CBOE). The CBOE Reference Manual |8~ suggests that increased income is the primary motive for writing covered calls. The manual states:

Covered calls usually appeal to the investor who is willing to assume a limited rate of return in exchange for reduced risk. Incentives for covered writing include the following: Increased Income.

A primary incentive for covered call writing is to increase the income from a portfolio. |8, p. H1~

Recall that the RIA Personal Money Guide |34~ suggests that investors think of call premiums as "premium dividends." Recall also, that Merton, Scholes, and Gladstein |27~ tried to educate investors to see that the call premiums are not "extra income to be added to the normal return on the stocks," but a transfer of money from capital.

The central hypothesis of the behavioral life cycle theory is that individuals have varying degrees of self-control difficulties associated with either myopia or weakness-of-will. Myopia and weakness-of-will interfere with the ability to defer gratification in a rational manner. For example, a self-control difficulty may lead people to save less than necessary to finance their rationally determined needs during retirement. People are generally aware of self-control difficulties and take steps to avoid them. For example, the rule of "don't dip into capital" allows consumption from current income, including dividends, but not from past savings that are framed as capital.

Individuals who wish to limit consumption from their portfolios can choose stocks with low dividends. Those who wish to consume more can select stocks with higher dividends. Retirees, who have no regular labor income, are most likely to favor stocks with high dividends. This helps them consume from their wealth without overconsuming. Consequently, dividend yield in the portfolios of individuals can be expected to be higher in the late parts of the life cycle than in the early parts.(10)

We suggest that call premiums play a role that augments the role of dividends. Call premiums that are framed as income allow levels of consumption beyond those feasible with dividends alone and without violating the rule of "don't dip into capital." Our suggestion is consistent with the observation of the CBOE that users of covered calls are motivated by the desire to increase income. Our suggestion is also consistent with the findings in the Louis Harris Survey |23~ that older people use covered calls more frequently than younger people, and the RIA |34~ suggestion that investors use covered calls to augment income from dividends so as to earn annual returns of 11% to 19%: regular dividends of four percent to nine percent and premium 'dividends' of seven percent to ten percent.