Nudge economics

My paternal grandfather fought for Britain in the War, and on his return took up business as a shopkeeper. He always seemed like a fairly rational fellow. And indeed, rationed! - for food and petrol rationing continued for half a decade after the War ended. The wartime generation was fairly conservative and risk averse in its attitude to private debt.

His wife (my grandmother) was a successful dentist (imagine - a dentist in a country of Brits with all those bad teeth!) and when she retired she deposited 75 pounds in a Post Office Savings account for me and an equivalent amount for each of my brothers.

75 pounds was a heck of a lot of money back then and it seemed an unthinkably large sum for a child. My brothers and I used to calculate how many lollies we could theoretically buy with it when we were old enough (hmm, what was I saying about bad teeth?).

When we were teenagers my father allowed us to spend the money as we saw fit (libertarian), on the proviso that we bought something of lasting value and not just lollies (paternalism). He let us do what we wanted with it but just gave us a nudge in the right direction. My older brother went inter-railing around Europe with his windfall. I bought some new cricket gear with mine.

Irrational decisions

Economics for many years suffered from one glaring shortcoming: its underlying assumption that we as humans act rationally. But we don't. We all learned at school that fatty foods are bad for us, cigarettes can cause illnesses, alcohol is bad for our livers and so on. We should all exercise daily and eat our five fruit and veg. In a rational world, if we put on weight, you'd think that we would take immediate corrective action, but as a nation, it seems to be otherwise.

I previously blogged about Adam Smith's invisible hand theory which was based largely on the assumption that people act as rational profiteers, and neoclassical economics was founded on the principals of rational human behaviour.

Behavioural economics

Over recent decades, these failings were gradually realised, and a new field of behavioural economics sprung up in the 1970s, which studied the relationship between mind and body and what drives us to act as we do.

The pioneers of behavioural economics understood that humans do not act rationally and instead frequently use mental shortcuts in order to make decisions, perhaps at various times based upon past experiences, a bias towards favouring the status quo, following a herd mentaility or sometimes based upon how a situation is 'framed'. We can be influenced by many biases.

Anchoring bias

Anchoring is a cognitive bias which causes us to rely heavily upon the first piece of information we encounter when making decisions. The first piece of information is known as “the anchor”.

For example, in one test a group of people was asked to write the last two digits over their social security numbers. And then they were asked how much they would pay for a bottle of wine. Those with higher digits on their social security cards indicated that they would pay more, on average, for the bottle of wine. Similar tests continued to yield similar results.

The initial price offered for a car tends to have an unnatural bearing on the remainder of the negotiation, regardless of what the seller initially believed a fair market value for the car to be.

The most common anchor in share investment is the price which investors buy a parcel of shares at. Logically, once you own a parcel of shares intended for a long-term investment – tax issues aside – the price you paid for the shares should be irrelevant. Instead, periodically the investor should consider the future prospects for the company and determine whether the shares held still represent good value by comparing to the market price last traded to the calculated value of the company.

Does this happen? Not often enough. Instead, most amateur investors become transfixed with the price which they paid for the shares. If the share price has gone down since they bought in, they swear blind that they will not sell until the parcel of shares is showing an investment profit.

Unfortunately this is very often what catches amateur investors out. They allow the market value to fall and fall…and fall, until finally they can take it no more and sell out at the very bottom of the market. By anchoring themselves to the price paid for the shares, they stop looking at the investment rationally by asking “would I buy shares in this company today?” and instead say “I’ll sell when I’ve made my money back”. They delude themselves that a loss is not real until it is crystalised and thus jeopardise their entire investment account through this one act.

Think back to the example of the car I referred to earlier. It’s very similar when it comes to property negotiations. The first offer made for the property very often becomes the anchor for the remainder of the negotiation process.

Nudge economics

The realisation that people do not act rationally is vitally important. It is no good for governments and central banks to set policies which work on assumptions of rational behaviour, such as, for example, allowing individuals to take on as much debt as possible. A rational person would not take on more debt than they could afford to pay back, and yet, people are not rational.

The implication of this is that we can expect policy makers to gently nudge us in a certain direction. Free markets are a great idea in theory, but in reality, policies will be put in place to manage consumer and individual behaviour.

The posh phrase for this is 'libertarian paternalism', more commonly known as 'nudge economics'. An example? Through the 1980s it was gradually realised that Australia was undergoing a major demographic shift and that our pension system was in need of reform. In 1992, Keating's Labor government introduced the Superannuation Guarantee legislation, which made contributions to pensions compulsory. It was considered to be in the best interests of the population to force contributions to be made.

Nudge economics is a delicate balancing act and dangerous in the wrong hands - where should governning bodies stop? Should they tell us how to spend our income and how much to save? Should they tell us when and where we should buy a house? Should we be allowed to decide whether to give blood or should healthy individuals be compelled to do do? Should organ donation be compulsory? What about our health? Marriage? Our education?

Market manipulation

Our investment markets will be heavily impacted by policy decisions in the coming decades so it will pay to understand the motivations behind and the consequences of policy-making. Central banks overseas have been engaged in heavy 'printing' of money which distorts share and commodity markets.

Australia's property markets will be manipulated by central bank policies. The RBA will use low interest rates to stimulate dwelling construction, yet the Reserve will not turn a blind eye to asset price bubbles. Meanwhile, APRA will keep a close eye on deposit growth and bank lending practices and ensure than standards are maintained. At the state level, first home owners grants will be used to 'help' buyers into the market. When markets next weaken once more, rules restricting foreign ownership may be relaxed, and so on.

All of these issues distort the markets and 'nudge' vested interests and individuals in the desired direction. Now, if you'll excuse me I'm off to calculate how many lollies I could buy for $10,000...