WEEK OF AUGUST 25, 2008--MAKING SMART DECISIONS

A Univ. of Chicago economist and Harvard Law Professor, Richard Thaler and
Cass Sunstein (the last is advising Barack Obama), have just come out with a wonderfully common sense book entitled, “Nudge, Improving Decisions About Health, Wealth, and Happiness”, (Yale University Press) that may help us to make smarter financial decisions.

Their thesis is that no decision is made in a vacuum. Context helps determine how content is understood, whether in a supermarket line, saving with a 401(k), or buying stock. Their book is based on research that shows people frequently make bad decisions because they don’t take into account the context or circumstances that can influence their decisions.

It is therefore important to provide guidelines or regulations that support wise decision making. So investing in “free markets and open competition (i.e., without regulation) will tend to exacerbate rather than mitigate the effects of human frailty,” say the authors. Unregulated markets tend to benefit insiders, in other words, who tend to be the most strenuous objectors to market regulations.

A simple example of nudging is the supermarket displays. How food items are displayed in supermarkets helps determine which are purchased. Sales and Public Relations people know that presentation is a big factor in sales. Even “small and apparently insignificant details can have major impacts on people’s behavior,” say the authors.

The authors’ goal is to ‘nudge’ people toward healthier, safer, more prosperous lives, says one reviewer. I agree with their thesis because it reinforces Dr. Robert Shiller’s bestseller, “Irrational Exuberance”. He predicted the dot-com stock market bust, as well as the current housing downturn that I have mentioned in past columns. Dr. Shiller’s research found that most investors follow their emotions in making investments, rather than do real research.

Messrs. Thaler and Sunstein take this understanding to another level, by recommending ways to correct the ‘bias’ in order to make more intelligent decisions. The first priority is to set up policies—whether by government or an employer that enable smarter outcomes by clearly explaining the choices. They recommend buying health insurance with the largest deductible that is affordable, for instance, since studies have shown that overall costs tend to be lower. This is something that insurance companies will not tell their clients.

Much decision-making must take into account a basic human trait. It is called cutting corners, inertia, or mental laziness, if you will. However, I believe consumers also have a basic common sense that can protect them. If consumers are given all the facts, they will make smart decisions. But it will take a greater effort by policymakers who formulate the rules and regulations that govern commerce—and prevent the negative ‘nudging’ of those who try to influence what is not in the consumer’s best interest.

© Harlan Green 2008