The Nudge Unit Goes EAST; Investor Funds Go West

Applied Psychology

As we saw in SCOTUS Breaches the Efficient Frontier, behavioral finance is (finally) beginning to be applied to the real world. Over in the UK the Behavioural Insights Team, aka the "Nudge Unit", has been using behavioral techniques to help improve citizens' responses to various government initiatives: getting people to pay their taxes, improve their health, increase the number of organ donors and so on. 

Since being spun out into the private sector the unit's range of programs has broadened and the results of their work look increasingly impressive, if not downright worrying. However, what is really interesting for us is how the insights the team is revealing are applicable to investors. Because, when you really think about these methods it turns out that they're already being applied. To us.

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Forsaken Liberty, A Behavioral Legacy?

Nudged to Conservatism

One of the recurring themes we keep hitting here is the balance between freedom and behavioral intervention.  Nudge theories, for instance, assume that pushing people in a direction that’s good for them is an unadulterated benefit to humankind.  Yet history suggests that this kind of paternalism is a gateway to much more serious interventions, when governments decide that they know best for us.

In general economists, you’d think, would be soundly against such interventions.  After all, what is the point of studying free markets if you don’t think free markets should be the preferred operating mode for people?  Yet an underlying assumption of liberty seems to lull even these arch adherents of market forces into a preference for conservatism.

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Have You Been Nudged Today?

Quills and Nudges

The British Civil Service is not a body known for radical change; it’s never quite got over having to give up the quill pen and tends to view with suspicion newfangled ideas like computers and women in the workplace. Despite this it’s currently at the heart of a large scale experiment on the use of techniques from behavioral science, aka, “nudge” theory.

Sitting at the center of UK government is the Behavioural Insights Team (BIT), which is tasked with using behavioral approaches “as an alternative or complement to regulation or bans”, while achieving a ten-fold return on the cost of the team. They’ve just released the results of their first set of trials on fraud, error and debt, and these suggest they’re likely to continue, as the potential savings look like they’ll be quite significant. Wherever you are, you can expect to be nudged, prodded and cajoled into being a better person; or at least one that pays their taxes and turns up to doctors' appointments on time.

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Get Rich, Flee Temptation

Double Your Salary

Let’s say you were made an offer in return for giving up your favourite treat for a month: let’s say you were told you would double your monthly salary - forever - if you abstain from alcohol or coffee or heroin or whatever for just four weeks. Would you take this deal?

It’s a no-brainer, of course, which is why it’s exceedingly odd to discover that this exact deal is one that many of us are unable to make. Human lack of self control is a remarkable thing, but it’s made many times worse by financial services offers designed to lead us into temptation.

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Lifestyle – Are You a Bond or a Stock?

A Default Lifestyle

Over the last few decades governments have been increasingly moving retirement investing decisions away from companies and onto individuals. Unsurprisingly – at least to anyone who spends any time in the real world – this has led to a lot of poor pensioners and rich fund managers. Slowly, the world has begun to recognise that simply entrusting people with responsibility for managing their own savings is quite a dangerous thing to do: people don’t behave as the models predict. Frankly people don’t even behave as they themselves predict.

In response to this we’re beginning to see the creation of a set of default investing options designed to remove some of the behavioural effects from the process. Amongst these is the idea of the lifestyle fund which defaults investors into a set of investment options that changes as they get older. While this is, in theory, a goodish idea, it doesn’t come close to addressing a fundamental problem which is that people’s wealth is constituted of both their savings and their ability to earn in future. If your job is safe as a bond then investing in shares is probably a good thing, but if it’s not then the default option may be utterly non-optimal.

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Unpredictably Rational

Common Sense

As we go about our everyday lives we don’t spend a lot of time reflecting on the irrationality of the people around us. Certainly from time to time people do stupid things, but by and large most of us make it through most of our days without driving the wrong way up roads, roasting our dogs in microwaves or buying stocks in stupid companies. Even when we do odd things there’s usually some recognisably rational reason for us doing them.

This version of human rationality is virtually unknown to all brands of economics which largely insist on defining rationality in an irrational way and then sniggering at the human race when it fails to live up to the standards that some rather over-focused economists think it should. The problem for them is that we’re not the irrational ones, they are. The problem for us is that the people that matter listen to them, not us.

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Save More … Tomorrow

Stop Lecturing, Start Helping

The investment maze we need to navigate gets ever more difficult. We’ve seen that investment advisors are unconsciously biased against us (Disclosure Won’t Stop A Conflicted Advisor) and that financial training isn’t much help (Financial Education Doesn’t Work). We’ve been told that long term passive investing in stocks is a bad idea (40 Years Of Bonds Beating Equities) and worst of all we can’t even trust ourselves, because we’re likely to goof off rather than spend time managing our investments (Retirees, Procrastinate At Your Peril).

All told, it’s not a happy situation for the majority of people who’d like a comfortable financial future. Given that behavioural biases are inadvertently responsible for many of the problems that beset us it would be nice if the psychologists stopped telling us what’s going wrong and came up with some useful suggestions. As it turns out they’re already on the case, the only problem being that we don’t, such is the law of unintended consequences, have a clue what the result of this intervention will be.

Positive and Negative Freedom

Mostly free market democracies like to offer free market democratic solutions to problems. The invisible hand of the market is presumed, all other things being equal, to find the best possible solution in a world of difficult trade-offs. The least good solution is usually regulation that seeks to make people behave in their own best interests.

This “least good” option isn’t simply rhetoric. The philosopher Isaiah Berlin elaborated the concepts of Positive and Negative Freedom in his lecture Two Concepts of Liberty. Positive Freedom is the freedom to do whatever we want as long as it doesn’t harm anyone else. Negative Freedom is the freedom that comes from being compelled to act in our own best interests – think fluoride in drinking water, DNA databases to catch future perps or forced retirement savings.

Unfortunately if you give a legislator an opportunity they’ll start doing what they think they do best – introducing more and more laws to protect us. Here in the UK we’re wilting under a plethora of Health and Safety regulations and Anti-Terrorism laws that are intended to save us from nasty things and horrible people. In consequence these regulations are simultaneously depriving us of many of our traditional freedoms and rights: this may be inevitable, but the creep of Negative Freedom is not without its dangers.

Berlin was one of the twentieth century’s more passionate advocates for Positive Freedom. As he pointed out, the century’s more despicable dictators rose to power on a wave of regulations which ended in coercion and dictatorship. Loosely fettered capitalism is a heady bulwark against such trends but the actions of financial engineers over the past decade have placed these freedoms in doubt.

Forcing Retirement Saving

In such an environment it’s unsurprising that the idea of coercing people into saving for their own retirements has become popular. If people won’t voluntarily do what’s in their best interests then we should make them is, in essence, the argument. The difficulty is, of course, that coercing people into effectively taking a salary cut isn’t a universally popular idea so governments have tended to put off the decision in favour of more enjoyable activities like spending the next generation’s tax revenues to ensure that bankers get paid their bonuses in the US or making sure politicians can afford homes for their ducks in the UK. Never let it be said that Britain’s global ambitions have waned since the end of Empire.

Fortunately behavioural psychology has come to the rescue of our conflicted leaders with useful evidence showing that turkeys can be made to vote for Christmas or Thanksgiving just as long as you make sure that their attendance at the ceremonial dinner is the default option. Government advisors are all over this idea, as you can probably imagine.

Default Options Work

Leaving aside the questionable issues of freedom and coercion for the time being, the idea of making people elect out of things they might otherwise choose not to do is a trick commercial companies have been using for years, as the heap of pseudo-junk marketing mail that arrives by snail mail and email each week is testament to. In terms of retirement savings, however, the idea of making the default option something to be automatically opted in to has been shown to have a positive effect on scheme enrolment.

The problem is that this is a one-off intervention. Simply agreeing to invest a fixed value or even a fixed percentage of your salary each month may not be sufficient, especially if the starting amount is small. The ideas of Richard Thaler and Cass Sunstein are at the heart of many of the new initiatives, sparked by their popular book Nudge, which explains how people’s behavioural biases can be used to persuade them to act in their own best interests.

Save More Tomorrow

Thaler’s already shown that these ideas can be put into effective practice through his Save More Tomorrow(tm) scheme. In this he and Schlomo Benartzi have neatly used a number of biases to persuade people to behave better. The design of the scheme is simple: when people enrol they agree that as and when they receive salary rises the amount subscribed to their retirement savings is automatically incremented, by an amount that grows in percentage terms.

This may not sound like much but the impact is remarkable. In the initial study there were two groups – one group that agreed to contribute a higher percentage earnings to start with and who needed to make further decisions to invest more and a second group with lower initial investments but which had agreed – by failing to opt out of the option – to contribute a rising percentage of their future salary rises. Three years and four rises later the Save More Tomorrow(tm) group was contributing significantly more than their counterparts.

What the scheme is doing is taking advantage of a number of behavioural traits that normally militate against long-term savings. Firstly there’s inertia – the tendency to let the status quo continue. So once opted in most people can’t be bothered to opt out. Secondly this overcomes the effects of lack of self control and procrastination – the tendency to prefer short-term immediate rewards over longer-term, uncertain ones. Thirdly there’s loss aversion – people don’t like seeing a cut in their take home pay. The scheme overcomes this because when a salary rise occurs people still see more money in their wage packet so they don’t suffer the disappointment of ‘losing’ money by opting to save it.

Nudge, Nudge

These concepts have got government advisors everywhere busily figuring out how they can ‘nudge’ people in the direction of current policy. There’s plenty of evidence that default options work – as noted in this fascinating recent Undercover Economist article the organ donor base varies by nearly 80% between the culturally similar Austria and Germany: Austria requires citizens to opt out, Germany to opt in.

As the same article points out, however, there is a problem in using these methods. We know that they work but we don’t know exactly why. And therein lies an issue, because when we nudge people in one direction we’re likely to find that although we may get the desired outcome, we may also cause them to do other things we don’t expect: consumers who save more for retirement in automatic schemes will be consuming less and buying fewer financial products, for instance.

Be Careful What You Wish For

We may think these are generally desirable outcomes but we don’t know what the effect will be of governments globally nudging their citizens in any particular way. We need to be careful what we wish for. This isn’t a new idea – Thaler and Sunstein have addressed the issue in Libertarian Paternalism is Not an Oxymoron. Here they argue that guiding people to better decisions by using their behavioural weaknesses against them is morally justified.

Isaiah Berlin would probably have disagreed, seeing any form of coercion as the thin end of a long wedge. If we could keep the areas of application of these ideas limited – to retirement savings opt-ins and healthy food choices, for instance – then maybe this would be OK. Unfortunately, the chances of governments limiting their interference to such straightforwardly uncontroversial areas is minimal. Look out for automatic opt-in clauses with everything – after all, it’s all in our best possible interests.


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