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Thursday, March 28, 2024

Choice Architecture And Retail Investors

Courtesy of ZeroHedge View original post here.

By Nicholas Colas, founder of DataTrek Research

The topic of today’s Story-Time discussion will be the behavioral economics concept of choice architecture, which says that how choices are presented influences what people choose. There’s “good” architecture, which nudges people into beneficial outcomes, and “bad” architecture, which leaves them adrift. Capital markets are rife with the “bad” sort of architecture, especially for the new crop of retail investors: myriad choices, randomly displayed. The only good news: it’s always been this way and capital markets/investors have done fine.

We’ve been fascinated by the behavioral economics concept of “choice architecture” ever since Richard Thaler and Cass Sunstein’s 2008 book “Nudge”, and it is the topic of this week’s Story Time Thursday.

The easiest way to explain choice architecture and the complexity it can create is with an example from a 2013 piece by Thaler, Sunstein and Balz (the editor for “Nudge”, link to the work below):

  • The food service director for a large urban school systems discovers that children tend to choose foods by where they appear in the cafeteria queue. Items presented at the start and end of the line are chosen more frequently, as are those placed at eye level.
  • Armed with this knowledge, should the director optimize the daily presentation of options based on 1) the healthiness of the food, or 2) at random, or 3) maximizing profit/minimizing cost?
  • The first option (healthy foods) is certainly what parents would prefer but one can see how choices 2 and 3 might be more popular if in place of a children’s cafeteria we were talking about a restaurant for adults. Choice architecture design is always a function of situation.

Now, it’s not just children that favor the easy-to-see or first option offered. Packaged goods companies pay supermarkets for shelf placement. Businesses pay Amazon and Google to put their ads at the top of relevant searches. Both examples are choice architecture “hacks” that may not yield the optimal result for the consumer. Regardless, they still work, as Google’s near $2 trillion market cap highlights.

Since the publication of “Nudge”, the primary way choice architecture has affected how economic choices are presented is in the use of default options to guide (“nudge”) people without taking away freedom of choice. Two examples:

  • Many US companies now make contributing to a 401(k) retirement plan the standard choice with a further default into a target date fund when new employees onboard. They can still choose not to enroll in the program, but that requires an explicit choice rather than the other way around.
  • When governments make organ donation the default option rather than “no donation”, enrollment in such programs increases.
  • Default choices are like salad placed at the start of the cafeteria buffet. You know it’s the “right” option, so you take it and that reduces the possibility that you’ll grab the burger and fries later.

Now, one area where choice architecture plays a prominent role in current capital markets is in how it effects decisions made by millions of new retail investors. There are thousands of individual listed equities in the US and at least as many exchange traded funds. Expand this investable universe to virtual currencies, and the list grows by another 12,000 potential choices.

Online broker Robinhood has an interesting approach to helping new accounts choose a stock to own: they simply put a share of a well-known name right into the account on sign-up. It might be JPMorgan (a $160 value) or Ford ($14), but on day 1 the client owns something. This is essentially a “default option” meant to engage the customer in the investment process and, hopefully, encourage further activity. In our view, this is an extremely clever way to break the logjam created by the thousands of potential choices that new investors face.

Go over to Coinbase, where there are a much smaller number of tradable options (63 just now), and you’ll still see choice architecture hacks meant to put a given option at “eye level”. For example, one offering called fetch.ai offers potential buyers $1 of value in that token for every video about the project that they watch. This is not quite as much of a “default choice” as Robinhood’s stock incentive, but the idea is the same: give users a reason to engage.

Even with these examples, the myriad of options available to retail investors obviously makes for something of an architectural nightmare, but this is not a novel problem. The new crop of millennial retail investors use sources like Reddit to find ideas amid the thousands of choices on offer. Their Boomer parents may scoff at this approach, but in their (relative) youth they paid 5-8 percent loads on mutual funds in large part because they too were overwhelmed by the choices on offer. Most of those fees went to brokerage firms in compensation for navigating the complex choice architecture that is Wall Street.

Yes, new retail investors could use some “nudges” to encourage sounder decision-making, but the historical track record shows this is very hard, as this brief personal story shows:

  • In a prior job I (Nick) developed independent research for sales to brokerage firms which had to show this work to their clients in the wake of the 2003 Global Analysts Research Settlement between the SEC, FINRA and 10 large Wall Street firms.
  • My firm made a ton of money on this product because the brokers involved had to pay $450 million over 5 years for work like ours.
  • But the reality was that very few brokerage clients (less than 100/month, typically) ever read the work despite it being both free and prominently displayed on investor portals.
  • On top of that, the further $85 million set aside from the settlement for “investor education” remained largely unused.

The bottom line to all this is that the choice architecture of investing is like a cafeteria with essentially infinite, randomly displayed choices and every demographic cohort that comes through the doors must find their own way. They make mistakes, they correct, they move on. Yes, it would be great if there were some systematic way to reduce the initial error rate. My own experience with the 2003 Research Settlement tells me there is not. In the grand scheme of things, that’s OK. The more important issue is that retail investors engage with financial markets and stay involved for the long term. Boomers managed this despite the 1987 crash and 2 bear markets. Millennials should be no different, a positive factor when considering long-term US equity returns.

Sources:

Choice Architecture (Thaler, Sunstein, Balz): https://dl1.cuni.cz/pluginfile.php/958113/mod_resource/content/0/06%20Thaler%2C%20Sunstein%2C%20Balz%20%282012%29%20Choice%20Architecture.pdf

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