Investment Decisions: Investors Can Be Nudged to Do the Right Thing

(MoneyWatch)  Research into human behavior provides us with many insights on how people can be nudged to do the right thing. In their book Nudge, behavioralists Richard Thaler and Cass Sunstein described the following real life experiment in tax compliance. Groups of Minnesota taxpayers were given four kinds of information:

• One group was told their taxes went to various public works.
• The second group was threatened with information about the risks of noncompliance.
• The third group was given information about seeking help filing returns.
• The fourth group was just told that over 90 percent of Minnesotans already fully complied with the law.

Only one of these "interventions" led to an increase in compliance. Can you guess which one? It seems that many people are more willing to violate the law because of the misperception that the level of compliance is low. When informed that most actually comply, they become much less likely to cheat - the likelihood of an outcome, good or bad, can be increased by just drawing attention to what others are doing.

In investing, there's a large body of evidence that investor returns are well below the returns of their investment vehicles. Driven by emotions like greed and envy in bull markets and fear and panic in bear markets, investors buy after periods of strong performance and sell after periods of poor performance. To avoid this type of behavior, you need to ignore market noise and resulting emotions and adhere to your investment plan.

While many understand this principle, it can be difficult to buy after periods of poor performance and sell after periods of strong performance. Never was this truer than during the last bear market, when investor discipline was put to its greatest test since the Great Depression. Many investors failed to rebalance during the crisis because they couldn't get themselves to buy stocks when the bottom appeared to keep falling out. Even keeping their heads (avoiding panicked selling) was difficult when many of their friends were losing theirs.

Advisors were having great difficulty getting even long-time clients, ones who had rebalanced through the bear market of 2000 through 2002, to do so. The lesson we learn from the Minnesota tax story is that "compliance" with investment policies could have been increased simply by advisors pointing out that other investors were continuing to rebalance.

Thaler and Sunstein teach us that when the incidence of undesirable behavior is high, it's still possible to nudge people to do the right thing.

Follow the series:

• Part one: How to Avoid Availability Bias
• Part two: How Framing a Question Can Change Your Answer
• Part three: Investors Can Be Nudged to Do the Right Thing