By: Paul Nixon, head of technical marketing and behavioural finance at Momentum Investments
From the words of Francis Scott Key that dubbed America “The land of the free”, which stuck, to the unforgettable Mel Gibson monologue where an army of painted Scots were willing to trade their lives for the freedom of generations to come – we celebrate our right to choose. Our destiny, our partner, our breakfast cereal and of course our unit trust. Battles have been fought, books have been written and Nobel prizes awarded and so it is reasonable to expect that the choice freedom extends should make us happy?
Pick up a marketing 101 textbook and it won’t take you long before you stumble across Michael Porter’s “generic strategies”. One of these is differentiation. The task here for marketers is to create the perception of something unique or different in a product or brand to position oneself as a particularly unique solution to a customer need. The result is clear as you walk through supermarket aisles. A plethora of colours, flavours, shapes and sizes, packaging and smells struggling for your limited attention. Our nature is to celebrate choice, but we don’t often think of the cost.
According to Cornell University you and I make roughly 226 decisions on food alone and a little over 35,000 remotely conscious decisions each and every day. Making decisions requires processing and in this regard our brain is “hungry” reserving a full 20% of our 100 watt energy production. Making decisions requires resources (energy produced from glucose) and your brain is particularly efficient at resource management and optimisation. This is precisely why it will try very hard to take shortcuts (this is exactly what a heuristic is) and will use your past experiences (or genetic memory) as much as possible in determining an appropriate course of action to save on valuable resources. We look at what others are doing and emulate the behaviour to save on time (better to run now and ask questions later) and/or energy. In cases where we force the deliberation process however and we’re low on fuel it can lead to very wonky decision making.
Think for a moment of your favourite chocolate bar. These are usually choices where there is a clear preference. For the purposes of this discussion let’s stick to chocolate and assume it’s the much loved Bar One for a 25-hour day filled with Zoom meetings. Paul Glimcher, a neuroscientist at New York University conducted a series of experiments where he asked people to choose between three chocolate bars. One of the choices presented was their favourite. Could you choose between a Bar One, Kit Kat or Crunchie (remember your favourite is a Bar One)? Of course and it would be a quick and easy decision. It gets interesting though when Glimcher ramps things up a bit and offers the choice amongst 20 other chocolate bars. What happens now is that Bar One lovers end up with different chocolate bars even when their favourite is in the mix. When questioned about their choice and reminded that their favourite was amongst the options presented, participants were left scratching their heads and couldn’t articulate the preference change with some even indicating they didn’t see their preferred option at all.
In a renowned study by Jonathan Levav, associate professor of business at Columbia University, it was found that parole hopefuls were anywhere between 2x and 6x more likely to receive a favourable outcome if they were part of the first 3 applicants when compared to the last three applicants in a giving sitting. They found that the likelihood of a favourable ruling peaked at the beginning of the day, steadily declining over time from a probability of about 65% to nearly zero, before spiking back up to about 65% after a break for a meal or snack. While initially this finding is quite jarring it makes perfect sense that as your power hungry brain runs out of gas as the day progresses given the high reliance on intense deliberation – judges are likely to become more conservative given the consequences of getting a decision wrong.
In making decisions neurons are sending each other information via electrical impulses – the stronger or more intense the pulse, the more likely it will result in some action and so these are termed “action potentials”. This takes valuable energy. In the 1960’s scientists hypothesized that the brain managed resources here by encoding data using the fewest possible pulses, just as communication networks strive to transmit information in the fewest amount of bits. This was confirmed as a key principle at play in the visual system in the 1990’s and neatly explains the concept of “salience”. To save on energy when your brain decodes visual information it will try to focus only on information it believes is useful to you. Walk into a room with three yellow walls and one with a bright blue splotch and guess where your attention is going?
To make this practical, Emily Singer of Quantamagazine elegantly explains these mechanics via a simplified example. If a thirsty monkey was making a choice between a teaspoon of juice and a full jug – the teaspoon jug neuron might fire at 1 pulse per second while the jug neuron fires at 100 pulses or spikes. The full jug appears attractive to the monkey and so it makes a choice. The waters get muddied however when the monkey needs to choose between a full jug and one that’s nearly full – so between neurons firing at 90 pulses versus 100 pulses. To solve this problem the brain recalibrates the scale and tones down the firing rate of the near-full jug to make the choice easier. Again however this calibration process takes energy.
Given the mechanics and resources required behind making relatively simple decisions like choosing your favourite chocolate bar, is it any wonder why investors struggle to choose between well over a thousand unit trusts with different styles, managers, salient points and are often left in a spiral of chasing past investment performance as a relative cue of value? This is one particular area where a plethora of choice has been detrimental to investor financial outcomes particularly when navigated without a financial professional to help cut through this clutter. This is precisely what outcome-based investing does – it packages the best available investments and investment managers to reach the investors’ personal investment outcome. This leaves more processing power for making important decisions like choosing our favourite chocolate bar and getting it right.