dark side of the nudge

Month: February, 2015

“The Cost of Active Investing” French (2008)

This paper estimates the unnecessary costs of active investing as 0.67% of invested assets per year compared to passive investment alternatives. Framed as a dollar cost, this equals $330 per year for every person in the US. The average investor’s mistakes really are expensive.

This paper doesn’t dwell long on potential causes, but does briefly mention the canonical behavioural finance cause: overconfidence. Yes many people are overconfident, but the consensus in favour of overconfidence is perhaps less unanimous in the psychological literature than some might expect. My personal opinion is that the many unique features of financial decision-making – payoffs spread over years and decades, shrouded costs, exponential compounding – are both more plausible and potentially more treatable than overconfidence. What this paper does show, though, is that the cost of personal investing as currently practiced is very high.


“Exploitative Innovation” Heidhues, Koszegi & Murooka (2012)

This blog has already covered the companion to this paper, which looks at equilibria in markets for deceptive goods. This paper extends that static model to the case where firms can invest in exploitative innovations. Firms can make either value-increasing or deceptive innovations. As in the previous paper, deceptive equilibria are more likely to occur in socially wasteful industries, since no firm can profit from educating consumers.

The first counterintuitive result is that incentives to create socially beneficial innovations are low if innovations can be copied. These innovations only increase consumer surplus, so there is no increased payoff to the innovating firm. Exploitative innovations are very different. These innovations are profitable if they cannot be copied, but are even more profitable if exploitative innovations can be copied. Spreading exploitation amongst competitors weakens the incentives these competitors have to educate consumers.

These theoretical results are interesting, but do the necessary modelling assumptions reflect real financial markets? The authors mention credit cards and mutual funds as two potentially relevant markets, and discuss these markets at greater length in their companion paper. These are interesting markets, but consumer exploitation in at least the mutual fund industry may be driven mainly by historical accident – how consumers weight fees against past returns. Mutual funds have not changed that much in the past few years (beyond increased choice and ETFs, etc). The gambling sector has seen much more innovation – being the first sector to properly monetize the internet. Furthermore, since gambling is purely zero-sum, gambling is more likely to meet the authors conditions for a socially wasteful industry. If consumers are not too naïve, then mutual funds do have a good potential to increase consumer welfare through easier access to diversification.

My last point is that any empirical study of exploitative innovation should be grounded by a psychological theory of decision-making. Any exploitative innovation is likely to reverse engineer some previously established bias.

“Inferior Products and Profitable Deception” Heidhues, Koszegi & Murooka (2014)

This paper builds on earlier theoretical analyses of competitively exploitative industries (e.g. Gabaix and Laibson, 2006), and lists conditions under which competitive industries converge on equilibria where naïve consumers are exploited. In this model firms compete to provide goods with variable social surplus by charging an up-front fee and then deciding to “shroud” an add-on fee, or “unshroud” and reveal the full fee of their product to naïve consumers. Sophisticated consumers exist in the market and know the magnitude of the full fee even if prices are shrouded.

There always exists an equilibrium where firms unshroud prices and naïve consumers are not exploited, but the authors argue that shrouded equilibria are more plausible when theoretically possible. A shrouded equilibrium can only remain if all firms decide to shroud their prices, so a key determinant is the good’s social surplus. If the product is socially valuable, then a single firm may find it profitable to unshroud its prices and turn all consumers sophisticated. But if the product is socially wasteful, then sophisticated consumers will not buy it, and unshrouding is unprofitable. For socially wasteful goods firms always maximize profits by shrouding prices and exploiting naïve consumers. The results continue to hold in multi-product markets, where sophisticated consumers buy the superior product, while naïve consumers buy a shrouded inferior product.

The authors suggest that real-world markets that are competitive but remain profitable are likely to involve exploitative price shrouding, and use mutual fund and credit card markets as two examples. The mutual fund market seems perfectly described as a shrouded multi-product market, where sophisticated consumers buy low-cost index mutual funds and naïve consumers buy high-cost actively managed funds.

Later on I hope to show how the results apply to the UK gambling market.