A lecture advertised as Behavioural science and biology have much to teach us about risk obviously gets my attention.
Below my main take aways on this FCA Insights Lecture (FCA = Financial Conduct Authority in the UK, similar to the AFM in the Netherlands, where I work). Read the full Insight Lecture delivered by Chairman of Oxford Risk, Lord Krebs on 22 November, 2017.
Talk in three parts:
- The biology of risk and decision making.
- The role of regulation versus informed choice
- How we might use insights from behavioural science to help consumers of financial products to make better choices. Key point in this final section will be that behavioural science has not displaced classical economic models, but has the potential to enrich our understanding of human decision-making.
So what do biologists have to say about risk?
Biological models derive optimality functions from Darwinian fitness, or a proxy for fitness such as food intake, growth rate, or reproductive success. It can be argued that normative economic models, because they have no external reference point equivalent to Darwinian fitness, have an element of circularity: utility is that which is maximised.
‘Expected energy budget rule’
Imagine a choice between two food sources, a ‘safe’ option and a ‘risky’ option. Which one is it better for the organism to choose? The theoretical answer depends on the organism’s internal state. (…) You may not think of peas as being very clever, but they have been equipped by natural selection with mechanisms for detecting nutrient concentration in the soil, a valuable survival device. When a seedling germinates, the young roots grow towards parts of the soil that are rich in nutrients.
Dener, E., Kacelnik, A., & Shemesh, H. (2016). Pea plants show risk sensitivity. Current Biology, 26(13), 1763-1767.
I want to make two general comments about this experiment.
First, the fact that pea plants follow the predictions of a normative evolutionary model of risk underscores the point that a brain, or conscious thought, isn’t needed to make the right decisions. Instead, the species we study rely on rules of thumb that have evolved because they yield the right answer, or at least an approximation to it.
Second, understanding these rules of thumb not only helps to gain insight into differences between the optimal solution and observed behaviour, but could also provide a general theory of decision making that complements and enriches the normative optimality models. There’s a parallel here with the difference between normative economic models and the rules that people actually use to make decisions (what Gerd Gigerenzer calls ‘fast and frugal heuristics’).
It’s easy to see how this finding, if applicable to humans, could be used to manipulate people’s choice of investment portfolios. But also “for good”, an example (from Knoef & Brügen, 2017):
Omdat hun default voor de meeste mensen de beste keuze is, heeft NEST de low risk-optie ‘NEST lower growth fund’ genoemd (in plaats van low risk), terwijl de high risk-optie ‘NEST higher risk fund’ heet (in plaats van high return).
The role of the regulator
If the construction of options for investment can be used to steer people’s decisions, should they be regulated, or is it a case of caveat emptor?
[W]hy regulators may not want to ban things. If you have objective criteria and apply them consistently, you may come up with some unintended consequences. Be careful of what you wish for.
My question, for discussion, is whether or not similar externalities of poor financial decisions by consumers could cause “indirect harms” and therefore justify regulation
labelling is not a panacea for the problem of dietary ill health. Again, I pose a question for discussion: are there parallels here for the labelling and marketing of financial products?
I very much agree with this last remark; warnings, disclosure and more inforamtion are (too) often hailed as the solution to everything.
Helping people to make better financial decisions
Encouraging people to make better choices through nudging, and as an alternative to regulation, has been advocated in recent years for many areas of policy, including financial services. The latest annual report from the Behavioural Insights Team or “Nudge Unit”, published last month, lists their key success stories from field scale trials. (…) On the face of it, these are impressive results, although it remains to be seen how long lasting the effects of nudges are. But even if these success stories are sustained, I think nudging has its limits. (…) nudges are likely to be of limited effect, compared with more interventionist measures such as investment in infrastructure, taxation or regulation. (…) No amount of nudging will compensate for lack of investment in the appropriate infrastructure.
we should not see behavioural science as an alternative to traditional optimisation models. In biology the actual mechanisms by which animals or plants make decisions are seen as complementary to, and not alternatives to, normative optimality models.
awareness of how people actually make decisions must be relevant to the ways in which advice is presented.
Our view at Oxford Risk is that the best financial decisions will be made by consumers
- when they have the relevant knowledge,
- when they are engaged with the decision and
- when they feel comfortable about making the decision.
The challenge for the financial services industry is to harness the power of behavioural science to help people to make decisions about their money that
- will give them what they want,
- what they need and
- what they understand.