As a financial planner, I believe that a large part of my job is to help people make good decisions. In our conversation, Greg Davies and I discussed a book called Nudge, by Richard Thaler, which suggests that positioning things just enough to nudge people in the right direction or to make better decisions is a good idea.
For the first part of this series, click here
Greg said that the academic paper which led to the writing of Nudge was entitled: ‘Libertarian Paternalism’, which puts forward the idea that you can simultaneously give people freedom to make their own decisions, while remaining paternalistic in the sense that you ‘nudge' people towards good decisions.
The whole idea is that we don’t push people towards what we think is best for them by constraining their options – we still let them choose freely on their own – but the way that we present options to them is important, because we’re all pushed around by the way things are phrased and presented to us.
Marketers have been using this for decades, and the whole notion of Nudge is one that’s quite powerful, but these techniques can be used to help people make better decisions, or they can encourage people into decisions that aren’t in their best interests.
Beeswax & Ropes
Greg uses the story Ulysses and the Sirens as a metaphor for building a framework for good decision-making, so I asked him to explain the story:
“The story of Ulysses is a close parallel to what we’re trying to do. In the story, Ulysses is sailing home from Troy (as per Homer’s Odyssey), a voyage that takes 10 years and is full of calamities.
One of the calamities is that the crew encounters the Island of the Sirens. They’ve been warned in advance, so they know it’s coming. The Sirens are described as beings which sing such beautiful songs that everyone who hears them jumps overboard to their deaths while in a frenzy of excitement.
The important thing here is, like much of the financial services industry, Ulysses knows what the theoretical optimum thing to do is. He knows what the optimal risk-adjusted returns are that maximise choices – you want the benefit of hearing the Sirens’ beautiful call, but you don’t want to incur the harmful, negative consequence of death.
The optimal strategy is to employ steel willpower; you listen to the Sirens’ call and say ‘thanks’ and sail on home. Unlike most of the financial services industry, and indeed economic and finance theory, Ulysses is aware that he’s human and not entirely rational at every point in his life.
He’s aware that he’s fallible and will have emotional responses to things which might lead him astray in the moment. So, what he does is to take steps to control his own behaviour in times of stress. He gets his crew to tie him to the mast with ropes, so he can hear the Sirens’ call but he can’t jump overboard.
They all have to block up their ears with beeswax, so they’re immunised against the Sirens’ call. Essentially, what they’re doing is at a cost to themselves – either they lose the benefit of hearing the call, or they have to endure the stress of hearing it but not being able to do anything.
It’s costly for them to do this, but they’re buying themselves emotional insurance. They’re purchasing for themselves the emotional resilience to withstand the temptation when it comes.”
This is exactly what happens in a lot of financial decision-making. At every point along the investment journey, we are faced with temptations, emotional responses, nagging doubts and gut responses to stories we’ve read or heard. Most of these things are harmful to our long-term returns. These are the immediate context and moments that for a long-term investor are harmful.
The position of classical finance on this is to ignore it and turn your emotions off. The position of behavioural finance is more subtler. It says: “There’s nothing irrational about us needing to feel emotionally comfortable along the journey.
We’re human, these nagging doubts exist and we can’t turn them off. It’s much better for us to acknowledge that and to take steps to protect ourselves against it, rather than to pretend we’re superhumanly rational all the time and then watch ourselves fail expensively.”
The position of behavioural finance is what we should be looking to do, which is to acknowledge our human frailty, and find efficient ways of planning for it in advance, rather than trying to pursue this unreasonable, unattainable, theoretical perfection.
To put that in finance terms: “Instead of seeking to maximise risk-adjusted returns, which is all that the theory tells us to do, most investors want the best performance they can get, relative to the stress, discomfort and anxiety they’re going to have to endure along that investment journey.”
Next week, Greg and I discuss some classic investor behaviours
Read the next part of this series here.