Prohibition is not a ‘nudge’

One of the concerns human financial advisors often express about using an automated advisor is that they make it too easy to change your allocation or trade. I don’t think that simply layering on frictions or completely prohibiting such things is a true solution though. Human advisors themselves don’t only make it hard for their customers to trade.

They are a firebreak which provides targeted real-time education, a less emotional counterweight, and a reminder of the plan the client was aiming to adhere to. All these approaches are also applicable in a digital advice service, and inform designs I’ve been involved in developing.

One of the principles I try to follow to is a practical form of Libertarian Paternalism. I’m paternalist because as an advisor, I have to have a view about what is right for the customer, and attempt to nudge them towards it. But libertarian because … prohibition doesn’t work. Simply outlawing something just makes it go underground, where it’s less moderated and more likely to cause harm.

Telling a smoker to stop smoking is good advice. But for many smokers, it is unlikely to be effective advice. Conversely, no good doctor would never tell a non-smoker to start chewing Nicorrette or Vaping. Yet these forms of advice may be the most effective advice for a smoker to receive. Telling a customer to ‘do nothing’, while it might be technically correct, might not be as effective as helping them to ‘do less than they would otherwise.’

This general strategy is often called harm reduction – it doesn’t try to eradicate the behavior, just minimize the resulting harm from it.

If an advisor strictly prohibits various harmful investing activities against the wishes of a customer, the most likely result is that they’d have (the impression of) a very well behaved customer base…  of customers who don’t really need behavioral help. All the customers who need coaching will likely have just ‘gone underground’ elsewhere, to a broker who let’s them have a bit of fun.

So what is the libertarian paternalist behavioral practical approach? (Wow, that was a mouthful!) Great advice incorporates the messy reality of human psychology – our desire to beat the neighbors, our weak willpower, our myopia, our inconsistency. It can even turn them into strengths. Here’s a list of things I suggest to help a customer avoid a mistake:

    • Educate: always the first stop. Targeted, rational education can help them understand a concept or idea for a lifetime. But it requires a rational frame of mind, effort and buy-in to learn from the customer, and time.
    • Counter-bias: find something emotional that works in the opposite direction. If a customer wants to sell everything in a taxable account, remind them of the capital gains tax due, and how they’ll pay for it. This is a bit of “an enemy of my enemy is my ally”, but it can work.
    • Use self-control contracts: ahead of time, when heads are cool, have them sign up for some form of self-control: cooling off periods, two-step verification, phone-a-friend.
    • Offer harm reduction alternatives: Rather than sell everything, take enough money off the table to make them feel safe. Use mental accounts to segregate risk into short-term and long-term buckets. Encourage customers to make moderate adjustments rather than extreme ones.
    • Set up a recovery plan: Half the harm often comes from not ‘snapping back’ to where they should be, after the storm has passed. Help them get re-invested at the right levels as quickly as possible. Even make it part of the original decision, ‘yoking’ the two choices.

Much like the best doctors often rise to the challenge of the toughest cases, an advisor should try to help not just the easy cases, but also the black sheep. You won’t always be successful, and you should be careful to not allow them to monopolize your time, but you should try.

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