Basis Points: A View From the Hills

The Decoy Effect and Risk Tolerance

October 2016

The Decoy Effect and Risk Tolerance

by admin on October 15, 2016

When given the option to choose between two products or services, consumers tend to focus on the advantages of the two choices relative to their needs. When the consumer perceives their need as small, they gravitate toward the limited service or smaller (less expensive) product. When you insert a third choice or “medium” into the mix, the brain tends to go haywire. Choosing between the merits of two distinct options is what the human brain was designed to do. Choosing the best among three options is not.

The introduction of this third option creates a response in the human brain that has come to be known as “The Decoy Effect”. Traditionally, restaurants and movie theaters have added an uneconomical medium choice to enhance the perceived value of the larger “target” size they want consumers to buy. Magazine and subscription services have employed the tactic as well to great success.

Dan Ariely, author of Predictably Irrational tested this phenomenon with his MIT behavioral economics class. He gave his students the following choices of subscription services from the Economist.

  • Option 1 – Web Subscription – $59
  • Option 2 – Web and Print Subscription – $125

Faced with this choice 68% of students chose the cheaper web only service, while 32% chose option 2. Ariely, then added a third option and presented the choice to the other ½ of the class.

  • Option 1 – Web Subscription – $59
  • Option 2 – Print Subscription – $125 (Decoy)
  • Option 3 – Web and Print Subscription -$ 125

No member of the class chose the decoy option. These are MIT students after all. But the impact of that decoy option profoundly impacted the eventual choice nonetheless. When faced with choosing between the three options 84% of students chose the more expensive service while only 16% chose the web only subscription.

Apple Computer has mastered the decoy effect, often creating a phone or ipod category that does nothing more than move the consumer toward the higher end model. The Apple 5C was largely regarded as a failure in that customers overwhelmingly chose the high end model over the 5C. Since profit margins on the higher end phone were much higher than the 5C, Apple may have gotten what it wanted all along, making the 5C potentially the largest and most successful decoy product in history.

Confusion and the Decoy Effect

When an already complicated decision is coupled with a decoy option that is not obviously deficient, consumers tend to choose the medium option in larger numbers. Politicians often fight for the moderate position in the minds of voters, because 34% of the voting public identifies themselves as such. As the debate between liberal and conservative has become more stark, voters are self-identifying less and less as moderates. In 1992, when America had its last credible three candidate presidential race (apologies to Ron Paul and Ralph Nader), moderate identification was over 43%.

Risk Tolerance and Moderate Bias

When investors are asked to weigh in on their investment risk tolerance, they are often given at least three choices from which to choose. Conservative (low risk), Moderate (medium risk), and Aggressive (high risk). The overwhelming winner amongst all age groups is the moderate choice. Markets seem to be able to impact investor behavior on the margins, but regardless of the market conditions of the day, the data point to an overwhelming majority of moderates in the investment community.

Decoy-Effect-1

Why is this? For one there is a relative safety associated with taking the middle of the road option. It may not be the correct option, but it surely will not be the most incorrect. This is especially true for first time investors. Asking someone to determine their tolerance for risk when they have yet to experience it, is like asking them to predict whether or not they will like a food they have never tasted.

While it is possible to examine personal traits, market views and beliefs to get a glimpse into the risk profile of an individual, the only real “proof” of risk tolerance has to wait until risk has to be tolerated in the first place. There are also personal bias expectations amongst potential investors with regard to what type of investor they should be that complicate the process of risk tolerance selection.

In many regards, the moderate label is at best just a starting point for most investors and needs to be treated as such. As more data is gathered and investment experience (both good and bad) is under our belt we should be in a better place to reexamine our risk tolerance and reshape it over time. Unfortunately, for too many investors, this initial choice made with limited information becomes a permanent fixture of their investment plan.

The Price of Moderation

In order to end up with a moderate risk profile, investors have to own investments that help them get there. This requires adding investments to the mix that are non-correlated (bonds to a stock portfolio and stocks to a bond portfolio). But over time moderation has its price. Consider this example: John, Jane, and Tracy all inherited $1,000,000 from their father in 2005. Prior to this, none of the children had any experience or interest in the investment world. John was adamant about his conservative risk tolerance and selected a portfolio characterized by the Morningstar Conservative Target. He was very happy with his choice during the financial crisis and stayed true to his conservative nature throughout. After ten years, his initial $1,000,000 investment had grown to $1,560,000.

Jane was more inclined to go with an aggressive approach. She viewed her inheritance as found money and doubted she would need to access it given her successful career and good existing financial position. Her stance was rewarded early on with substantial excess returns. She lost almost 50% during the financial crisis, which was very difficult, but she managed to make it through. Her balance after 10 years was approximately $1.85M.

Tracy was totally overwhelmed by the decision and chose a moderate portfolio with little basis for doing so other than it was between what John and Jane had chosen. In the early years, her sister had prodded her to take on more risk. Once the market corrected, it was John telling her to follow his more conservative stance. Had she been able to hold to her moderate stance, her results would have been quite good, ending the 10yr period with $1.78M. Unfortunately, she could not.

Decoy-Effect-2

After two years of having to listen to Jane brag about her superior investment strategy, Tracy decided to switch to a more aggressive portfolio. Jane had a blossoming career and a salary to match, Tracy did not. In fact, Tracy had to dip into her savings from time to time to cover any extraordinary expenses since her salary was barely enough to make ends meet.

After a few months of positive performance, the bottom fell out. Her investments dropped sharply. Her company downsized, forcing her to undergo a prolonged period of unemployment. Her brother John was in her ear constantly with one dire prediction after another, all of which seemed to be coming true. After a particularly painful day in the spring of 2009, Tracy pulled the plug altogether. She had lost all she could afford to lose.

The market began to recover almost immediately and by 2011 both John and Jane had an almost identical investment balance. During that time, John’s conservative nature had been validated. He never even considered chasing returns and never panicked. Jane’s patience along with her increasing income stream allowed her to maintain her investment objectives. Now ten years older and that much closer to retirement, Jane is reevaluating her risk tolerance. She isn’t sure that she wants to relive the past ten years of market volatility. The advantage that Jane has is experience. She has lived through the ups and downs of market and has a proven track record to back up her risk tolerance along with some valuable negative experience that she can use as she reconsiders what type of investor she want to be.

Tracy has all but lost faith in the market as a whole and more particularly in her ability as an investor. While John and Jane are looking forward, Tracy is stuck examining the past and where it all went wrong. In retrospect her mistakes appear to be all about timing. She got more aggressive at the wrong time and more conservative at the wrong time. She realizes now that the market cannot be timed, but here she sits with less than 50% of her original investment sitting largely in cash, wondering when and how to reenter the investment world. Her past experience is not an advantage to her, it is her largest obstacle to future success.

The Reality of Risk Tolerance

Risk tolerance is not purely an expectation of an investor’s emotional response to market volatility. It is a combination of the ability to handle risk and the capacity to handle it. Tracy focused only on her ability to handle volatility, and ignored her capacity to handle it. With a marginal job and an inability to cover any emergency expenses, Tracy was in the position of depending on her investment account to cover short-term needs. With that as a background, Tracy was never really a candidate to be an aggressive investor in the first place. She viewed her decision as no different from the one her siblings made when in fact it was totally different from the outset.

Tracy might have benefitted from the traditional bucket approach to investing. Rather than identifying herself as a conservative or aggressive investor, she could have identified pots of money with specific risk tolerances.

Decoy-Effect-3

Her cash bucket would hold an amount of money that she could draw from to cover emergency expenses and use to supplement income for shorter periods of time. Her conservative bucket would resemble the portfolio John had established and the aggressive bucket would hold investments similar to those in Jane’s portfolio. The amount of money committed to each bucket would determine Tracy’s overall risk tolerance.

Perhaps just as importantly, the three bucket system would have allowed Tracy to make small changes to her risk tolerance simply by rebalancing the buckets back to their original amounts at the end of each year. If she had in fact wanted to get more aggressive, this would have happened naturally over time as her aggressive bucket gained more than the others and her cash bucket was being used up over time. If instead she wanted to get more conservative, she could refill the cash bucket with the assets from the more aggressive bucket.

A third and underrated benefit is that having the three bucket system provides a place for investors to receive positive feedback on their choices. Whether the market is up or down, investors can claim some solace in being right about at least one of their choices.

Risk Tolerance Takeaway

Measuring your own risk tolerance is fraught with potential pitfalls. Your own brain may fall for the “decoy effect” tricking you into selecting the wrong option. Assuming you can counter the decoy effect and properly quantify your risk, you should keep in mind that tour capacity to accepting risk is equally if not more important than your emotional ability to handle risk. Whatever your initial risk tolerance appears to be, you should understand that it is not a set it and forget it concept. Your risk tolerance should be measured regularly and your portfolio structured so that you can dial it up or dial it down as your capacity and ability to accept volatility waxes and wanes.

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When given the option to choose between two products or services, consumers tend to focus on the advantages of the two choices relative to their needs. When the consumer perceives their need as small, they gravitate toward the limited service or smaller (less expensive) product. When you insert a third choice or “medium” into the…

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