Applying nudge theory to private banking, or how to combat the trend towards uniformity
The 2017 Nobel Prize for Economic Sciences has been awarded to Richard Thaler, one of the founding fathers of behavioural economics. As a result, nudge theory, as popularised in 2008 by his hugely successful book “Nudge”, is back in the headlines. Co-written with Cass Sunstein, that book gives examples of how people’s propensity to take irrational decisions – caused by their cognitive biases – can be overcome by “nudges”.
Nudges involve using those biases to put people in situations involving choices, in such a way that they will be encouraged to behave predictably or take “good” decisions. Thaler and Sunstein also wrote about “libertarian paternalism”: paternalism because people need benign support when making choices, and libertarian because no option must be excluded in order to maintain their freedom of choice.
The doctrine can be applied in many different fields such as healthcare, the environment and savings. In the latter area, given the inability of Americans to start saving for their retirement early enough in their career, Thaler and Sunstein suggested to the authorities and companies that employees should be enrolled by default in their retirement savings plans, while giving those not wishing to save the chance to opt out. Since such opt-outs are rare, companies are seeing a surge in employee savings.
Nudges are easy to implement, effective and cheap. However, they also take responsibility away from individuals in some sense and create standardisation, and so can also have perverse effects.
As regards the supply of financial products and savings management services, the wave of regulation following the 2008 crisis has – with the aim of increasing transparency and investor protection – encouraged the development of standardised and, indirectly, index-based asset management.
“When the wise man points at the sky…”
In an attempt to diversify risk in order to manage it more effectively, and to increase clarity, the product range has become more index-based, at the expense of active management. By focusing only on relative benchmarks, the finance industry has lost sight of one of the main reasons to invest: to help people grow their savings, i.e. to achieve positive absolute returns. In other words, to make money.
“What wealth management needs is an incentive to create tailored solutions – instead regulations are pushing it towards standardisation.”
As Dominique Fière, asset manager at Amiral Gestion, recently said, “unfortunately, when the wise man points at the sky, the fool looks at the finger. The whole focus is on the index, and the rational aim of making money has been replaced by that of achieving a return similar to that of the index. There has been a shift from a system of absolute value – making or losing money – to a relative system, i.e. doing better or worse than the index, regardless of whether it is rising or falling.”
In some ways, the purpose of recent legislation – which will be bolstered by MIFID 2 in Europe and LSFin in Switzerland – is entirely commendable: allowing clients to choose the most rational investments in a fully transparent way. However, the result is increasing standardisation, with people being pushed to invest in the same products at the same time. We are seeing a concentration in volumes as heavyweight asset managers buy the same stocks without considering their intrinsic value, simply because they are part of an index tracked by their ETFs and other index-based products.
For the markets, this produces self-sustaining movements and lower volatility. For clients, the only way their objectives seem to be taken into account is by filling in a mandatory form, and investment choices are increasingly automated.
This tallies with certain banks’ enthusiasm for digital solutions, including “robo-advisors”, which are just another way of standardising choice while claiming to offer a more rational, low-cost way of investing. There is also increasing interest in risk premia investing: this is a sophisticated offshoot of index-based management that aims to standardise the way portfolios generate alpha by creating indexes that accurately reflect the various risk premia. When all the components of these new indexes have converged, herd effects and overvaluation will be rife.
It is worth asking the question: can the high-end private banking industry adopt standardised investing, or even robo-investing which, although complying with regulations, would involve no in-depth understanding of clients’ ever-changing needs? Absolutely not.
Breaking with the trend towards uniformity requires considerable effort. Private banks must continue to deliver individual solutions, and not risk destroying the value added that they have traditionally championed. The industry must remain focused on assessing clients’ needs, their financial expertise and their tax situation. It must understand clients’ ability to assess risk and their investment horizon, even though they may change often in line with financial developments. Digital tools must be used as a way of delivering a more customised service, not as a way of implementing standard solutions. Nudge theory is based on preserving choice: we must safeguard that freedom, rejecting solutions that, while claiming to protect savers, limit the possibilities available to them. That choice is vital both to the interests of our clients, and to the profitability of private banks.
CEO Private Banking