Wink, wink, nudge, nudge

I recently read ‘Nudge’ a book about decision-making by Thaler and Sunstein. The book left me with a lasting impression. The primary thesis is that certain people – dubbed “choice architects”- can play an important role in gently guiding decision-making. Their main rule is the application of “libertarian paternalism”, whereby choice architects can nudge people toward what are likely to be superior alternatives without (and this is crucial) in any way impeding their right to choose other options.

It should come as no surprise that an entire section of the book deals with investing. Financial advisors are perhaps the most influential choice architects people interact with on a regular basis.

That means advisors have both a great opportunity to direct informed decision-making and a huge responsibility to do so conscientiously.

Ironically, it was a later chapter – one that pointed out an opportunity to lower health care costs by removing the patients’ right to sue – that got me thinking about our line of work. The parallel was especially striking in light of recent discussions surrounding whether or not financial advisors should be held to a fiduciary standard. That’s something that has many commentators weighing in on the concept of both liability and the extent to which it might change the way advisors do business. The perverse notion the authors put forward was that American health insurance was akin to a lottery, given that it represents an opportunity for disgruntled patients to sue for malpractice.

My thinking was a little different. Given that financial advisors recommend investment products to clients, there’s an obvious similarity to physicians. What’s more, given that a recent SPIVA report showed that only about one in ten actively managed products has outperformed his or her passive benchmark (in U.S. Equity, Canadian Equity and International Equity categories) over the five years ending in 2009, what risks might advisors be taking (especially if they are deemed to be fiduciaries) if they nudge clients toward active options? Perhaps more disconcerting (because it offends the fundamental principle of libertarian paternalism) is: what if they do not offer a passive option at all?

The lottery metaphor is something I think of often regarding what we say to our clients. I know of few advisors that actively encourage their clients to buy lottery tickets. I personally believe this is appropriate because people have sometimes referred to lotteries as “a tax on the hopelessly optimistic”. The odds of winning make the prohibitive majority of lottery tickets an awful investment. My question is simple: whether the odds are one in ten or one in a million, is it appropriate to counsel someone to pursue a course of action where the statistical probability of a positive outcome is clearly against them?

At the very least, shouldn’t there be an element of necessary disclosure before recommending the course of action that involves such an improbably positive experience? Perhaps most important, if there’s even a small possibility that my concerns are valid and that the disclosure of active strategy limitations are advisable, aren’t the stakes going to be a whole lot higher if the choice architect advisors are being held to a fiduciary standard?

We all have a role to play regarding constructive behaviour modification for our clients. Thaler and Sunstein make it abundantly clear that people tend toward default options when they know little about competing choices that are anything other than rudimentary. Do you offer both active and passive investment options to your clients?

John De Goey, CFP, is the vice president of Burgeonvest Bick Securities Limited (BBSL) and author of The Professional Financial Advisor II. The views expressed are not necessarily shared by BBSL. You can learn more about John at his Web site: www.johndegoey.com.