This is a summary of a conversation between Shane Shepherd, Head of Research, Research Affiliates, and David Laibson, Professor of Finance, Harvard University, on 11 March 2019.
Shane Shepherd and David Laibson recently discussed Laibson’s research into self-control, in particular, an investor’s self-control or lack thereof in making buy and sell decisions, especially in periods of market stress. The video interview and transcript are part of the Research Affiliates’ Conversations series.
Laibson's research finds that changing the environment has proven to be much more effective than trying to talk people into changing their behavior.
Standard economic theory views people as rational decision makers and fully capable of successfully acting on their good intentions. The reality is far different. The field of behavioral economics examines how people actually behave and the consequences of their actions. Behavioral economics acknowledges that people can be ‘imperfectly rational’, and that while they have good intentions, they often have poor follow-through. Looking at economics through the lens of human behavior can produce more realistic and more useful expectations about markets and market participants.
Self-control — not always easy to exercise — plays a huge role in deciding whether to take an action that will have implications both in the present as well as down the road. Walter Mischel’s famous ‘marshmallow test’ illustrates exactly how difficult people find giving up current gratification for potentially greater gratification later.
In Mishcel’s research, the experimenter gives a five-year-old child a treat and walks away. But before leaving, the experimenter explains to the child that if he or she can wait to eat the treat until the experimenter returns, they will get two treats. Many of the children were unable to wait any length of time, while others were able wait the full 15 minutes until the experimenter returned. The children who successfully exercised self-control when left alone used a number of strategies to divert their attention from the treats.
A strategic framework for self-control
As adults, we also employ strategies to help us gain control over our instinctive responses and impulses. Laibson and his co-authors’ research lays out a framework for thinking about how we can gain more self-control.
Laibson prefaced the explanation of his research with Angela Duckworth and Katherine Milkman by saying:
“I think one of the interesting failings of human civilization is the principle that, somehow, we're going to make better choices by pulling ourselves up by our bootstraps and just deploying more willpower ... It turns out that other strategies are better at helping us improve our ability to self-regulate.”
Laibson gave a few examples. If we hear 'Everyone reuses their hotel towels', that's a way of conveying the message that everyone is pitching in to save water by reusing their towels, and you should too. This would be a cognitive (Ed, cognitive means involving conscious thinking), 'other-deployed' strategy. In contrast, a situational (Ed, situational means depending on a set of circumstances) involving an 'other-deployed' strategy would be when the hotel asks guests to make an active choice to reuse their towels, such as either placing them on the floor or on the towel bar.
A cognitive self-deployed strategy would be a self-generated deadline. For example, you really need to finish writing a report before a meeting the next morning, so you tell yourself that if you finish by 10:00pm you can relax and watch a show on Netflix. It's the carrot on a stick approach.
An alternative approach would be a situational self-deployed strategy in which you make a commitment to an external party. Instead of promising yourself a reward for achieving the work deadline, you make that promise to someone else, perhaps your manager. A commitment to an external party creates credibility for your promise and can be a very powerful way to ensure you follow through on your goal.
Interestingly, none of these strategies involve having more willpower. Rather, they all involve taking the limited willpower humans typically exercise and enabling it to go further.
Strategies to help save for retirement
Abundant anecdotal evidence and substantial academic research suggests that many people around the world are nowhere near saving the amount they will need to provide for a safe, secure, lengthy retirement. The research Laibson and his coauthors conducted shows that situational, as opposed to cognitive, strategies are the more successful way to help people grow their savings.
Cognitive strategies, in which we try to talk people into saving by either explaining how important it is or telling them how many other people are saving, work to some degree, but unfortunately fall short in offering sufficient encouragement to keep up the effort.
Compulsory savings, very much a part of the ecosystem of savings, particularly in Australia, is an other-deployed situational strategy, which by its very nature is quite successful. Mandating that everyone who gets a paycheck must put some of it away for retirement is a very effective means of building an individual’s savings. Private institutions encourage savings using less-strict strategies, such as defaults. If the employee doesn't wish to participate, they can opt out, requiring an action, a conscious decision not to save.
Strategies for impulse control in market downturns
Another area that suffers from problems related to self-control is investment decision making, or specifically, the desire to sell in the midst of a market downturn. When the market begins to fall dramatically and unexpectedly, many investors are plagued by a tremendous sense of panic. The impulse is to pull out of the market, to sell in order to avoid the negative feelings of being invested during a downturn, even though on a rational level they realize selling is likely not in their or their portfolio’s best interest.
The strategic framework just discussed as encouraging savings for retirement is useful in helping investors develop a plan for moderating impulsive behavior ahead of future market dips. Such a plan can support a more appropriate response by investors when the market takes an inevitable nosedive.
The message to investors is to resist the impulse to sell. “Sit on your hands.” Laibson recommends that, during unpressured moments, investors develop a strategy of being passive and of not trying to time the market. Thus in periods of market turmoil, when everyone is rushing for the exits and the panic to sell begins to make its presence known, the prepared investor only needs to remind herself of the cognitive strategy she’s developed to not overreact when the market is melting down.
Conclusion
Behavioral economics studies the ways people actually behave and applies these learnings to help people make better decisions for the long run. The recent research by David Laibson, Angela Duckworth, and Katherine Milkman explores strategies for enhancing self-control. These strategies can be either situational, which help us change our environment to have the appearance of more self-control or to make decisions easier for us, or cognitive, which are more of the educational variety.
They find that situational strategies tend to have ‘more bite’. Ultimately, as Laibson points out, changing the environment has proven to be much more effective than trying to talk people into changing their behavior.
Shane Shepherd is Head of Research at Research Affiliates LLC. This article is general information and does not consider the circumstances of any investor.