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.
At the center of the Behavioral Insights Team's approach is the EAST framework: to produce effective interventions they need to be Easy to understand and use, they need to Attract the attention of the target participants, they need to harness the power of Social networks and they need to be Timely.
You'll have to read the EAST report yourselves to get the full impact - and unsurprisingly it's very accessible and I encourage you to do so. However, the general principle is easy to state: the aim is to use insights from behavioral psychology to change peoples' behavior in ways that either governments or private sector organizations desire. Whether you regard that as a good thing or not is another matter, but the report is full of examples of how techniques are used to make the world a different, if not a better, place.
The "Easy" strand of the framework targets removing frictional costs; those apparently minor inconveniences that put people off whatever it is we want them to do. Default opt-in options are a favorite here, and are measurably successful whether you're looking at improving savings rates or increasing the number of organ donors. Interestingly even something as simple as directing someone directly to a form rather than to a webpage containing that form can push up response rates by 20%: adding auto-fill functionality will further boost participation.
There are two key messages: firstly if you want to improve response rates it's important to look at the details of processes, because even relatively minor simplifications can make big differences. The second is that if you want to change behaviors in more complex ways you need to break the process down into simple steps, and then remove frictional costs from each of these. Which all sounds very simple, but we all know how rarely these principles are put into action in the real world. Or are they?
For the second strand, the "Attract" leg of the framework, the key is to personalize messages. In a complex and busy world you first need to get people to pay attention, and then you need to incentivize them to respond. Personalizing messages is a very effective way of getting peoples's attention: one study on people who had failed to pay car related taxes found that simply including a picture of their car in the reminder was enough to improve response rates by nearly 20%.
Rewarding people for compliance is also effective: using lotteries rather than paying everyone invokes our love of a gamble and our inability to figure out simple statistics, for example. But incentives don't need to be purely financial - getting people to focus on their self-image as a voter increased participation in elections, for instance.
We're intrinsically social apes, so drawing on our social behavior is another way of trying to influence our actions. Pointing out that most people are compliant to some behavior will trigger our attraction to social norms - this technique has been used to increase charitable giving in wills by a factor of three, and to increase overdue tax payments by 5 percentage points (and over £200 million in total to the UK government).
Other work has been focused on social networks and particularly on reciprocity - people are encouraged to join organ donor programs by getting them to think about what might happen if they needed a donation, and elderly care support is being built around the idea that the help we give now will be given to us later in life. Also commitment devices, making public commitments to improve our behavior, are very effective: they have been shown to get people off benefits and into work, to improve saving rates and even to get people to file their tax returns.
Make it Timely
The same intervention can have significantly different outcomes dependent on when it occurs. One trial that the BIT ran targeted getting people to pay fines by sending them text messages: personalized messages sent at the final opportunity were very effective at increasing payments. In one US study quoted, the effect of getting people to sign a form before filling it in and after it was to increase honest reporting: people reported that they drove about 10% more.
Timing interventions to critical moments in peoples' lives - when they've had children, got divorced or been bereaved, can have much more impact than at other points. The trouble is that detecting those points can be quite tricky - but generally it's easier for governments than it is for corporations.
I think the critical points here remain the ones hidden in plain sight. Changing peoples' behavior is dependent on context and small changes can have disproportionately large impacts. But as the report points out people don't always do the things you expect - a number of the targeted interventions didn't work as expected and it's all too easy to get messaging wrong - letting people know that misbehavior is a social norm may well decrease compliance, for instance.
On one hand this is all relatively uncontroversial: the private sector has been using these techniques to fleece us for years without huge complaints, and using the same methods to make government more efficient and encourage positive behavior in citizens isn't exactly a terrible thing. But the concern remains as to the proper role of government: we may know, for instance, that people should eat less and exercise more but is it government's place to manipulate people to do so?
(Actually in the UK the answer is simple: yes, we have a socialized health care system which we're nearly all terribly proud of. In the US and other countries where health care is a private function it's a much more nuanced issue).
Moreover, of course, the issue of Big Brother government extending its reach beyond areas where there's a clear democratic mandate remains a lurking spectre. However, to be frank, the behavioral monkey is out on the loose and it's unlikely to ever be caged again. It's down to individuals to educate themselves about these issues: we can choose to comply blindly or not.
Lessons for Investors?
And on that note, if we were to take the lessons of EAST and apply them to investing we would imagine an investing service that removes frictional costs, is personalized, uses social norms to encourage participation and is able to prompt you at the precise moments you were most likely to invest. This would be a fully participatory investing service, which encourages the maximum amount of trading and is in the best interests of the retailers of these services and, therefore, unlikely to be in the best interests of us, the consumers.
Of course, this is almost precisely the situation we find ourselves in today. The private sector uses these behavioral techniques to get people to trade as much as possible because trading equals fees. Do we, as intelligent investors, think that doing what the securities industry want us to do is likely to be in our best interests?
We're being manipulated and, once again, we can choose to comply blindly, and see our money go West - or not.