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The Economics Nobel and Your Investments

Making good financial decisions depends on the 'Choice Architecture' around those decisions

The Economics Nobel and Your Investments

So the Economics (non) Nobel has gone to Richard Thaler, who once chided his fellow economists for forgetting that 'people were human'. It's a good joke because it has such a strong element of truth. All disciplines start with ultra-simplified models and but economists seem specially prone to believing that these models are useful. This is in contrast to those working in the sciences or engineering. For example, physicists--as a recent magazine article put it--don't believe that real objects are spheres in a frictionless vacuum. Similarly, people--being humans--do not behave as perfectly rational human beings.

As someone who's been interacting with investors for decades, I can vouch for the fact that there's a close parallel here to investing and one that's actually even more of a puzzle. It's more of a puzzle because while economists may irrationally believe that people--in the abstract--are perfectly rational decision-makers, investors tend to believe this about themselves! And again, with as little as evidence. In fact, a large part of following good financial advice basically amounts to recognising this, and then playing psychological tricks on oneself to overcome such instincts. The trouble is that an even bigger part of bad financial advice--and selling of financial products--is about exploiting such instincts.

The biggest example of a good psychological trick is the Systematic Investment Plan, or SIP. As I've written earlier, the real problem in investing in is not where to invest, but to invest at all and keep investing through good times and bad. Most of us invest sporadically, invest more when equity prices are rising, and then stop investing when equity markets fall. This feels like a natural reaction to most investors, perhaps because falling stock prices are presented as a crisis in the mass media. Of course, this is perfectly irrational. As an investor, in fact, as buyer of anything, you should want low prices.

SIPs are a solution but investors often see them as a rational, even mathematical technique to get better returns. An SIP means investing a fixed sum regularly, generally at a frequency of once a month. Since the investment happens regularly regardless of booming or dropping markets, investors automatically buy more units when the markets are low. This results in a lower average price, which translates to higher returns. It sounds like a clever investment technique, and it is.

But the real reason for the great returns that people get out of SIPs lies in their value as a psychological trick. When the markets turn discouraging, the general instinct of many investors is to stop investing, either because they are scared or because they are trying to catch the bottom. However, SIP investors - not all but most - tend to continue their SIPs. No action is required to continue the SIP--inertia itself will make you do the right thing.

To use the term coined by Thaler and Sunstein in their best-selling book Nudge: Improving Decisions about Health, Wealth, and Happiness, the 'Choice Architecture' is perfect in SIP investing. The first tool of Choice Architecture is the default, and in the case of SIP investing, it leads you down the right path.

There's another investing phenomena that becomes clear when you consider the Choice Architecture around it, and that's the way in which the long-term returns from real estate and gold investing are compared to financial investing. The investment returns from real estate and gold are always available in terms of total returns, while the returns from financial investments are (almost) always presented as a per annum rate. Over the last fifteen years, a piece of property has become 4 times in price, while a particular financial investment has had returns of 9.7% per annum. Which is better? They are exactly the same of course. However, 9.7% a year sounds like something barely more than what you get from a bank FD, while multiplying your money four times sounds like a big bonanza.

The Choice Architecture is terrible. The 'translation of attributes' part of the choice is the exact opposite of what it should be. Human beings are not capable of comparing a compounding value with one that is presented cumulatively, and that's a big problem in making good financial decisions.