How the 'Decoy' Effect Can Influence Our Investment Decisions

How do we recognize and protect ourselves from our irrational behaviors?

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Nicola Guida
Apr 18, 2021
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Introduction

As

Charlie Munger (Trades, Portfolio) has repeatedly explained, investors are continuously subject to many types of behavioral biases.

Even if we are firmly convinced we're acting on a rational basis, the truth is we're just "evolved animals," and only a few people know how to insulate themselves from the many negative influences that continuously lead us to make costly mistakes.

One of them is Dan Ariely, a professor of psychology and behavioral economics at Duke University, who devoted his life to discover and study the reasons why humans are so (unconsciously) irrational.

The decoy effect

In his book "Predictably Irrational", Ariely wrote that once when he was browsing the web, he stumbled upon a curious magazine subscription ad.

Here's what the ad consisted of (please note that I've a bit simplified the ad without altering its basic content):

  • Web subscription: U.S. $59.00 - One-year subscription to the magazine website.
  • Print Subscription U.S. $125.00 One-year subscription to the print edition.
  • Print & web subscription U.S. $125.00 One-year subscription to the print edition and to the website.

He read the ad multiple times to be sure he was not missing anything, but there was absolutely no reason for a subscriber to choose the second option.

Once a typo error was ruled out, he started to think deeper about the rationale of the offer.

He then realized that the magazine team was trying to push people to skip the internet-only option and jump to the more expensive one (internet and print).

But how would they actually achieve that? The answer is: by introducing a decoy, a sort of no-brainer. Almost everyone, indeed, would think that choosing the second option would not make any sense and focus on the third option, meanwhile underestimating the first option (which would clearly provide lower margins to the magazine company).

Why do people behave this way? Here's the explanation provided by Ariely:

"[...] humans rarely choose things in absolute terms. We don't have an internal value meter that tells us how much things are worth. Rather, we focus on the relative advantage of one thing over another, and estimate value accordingly."

In order to prove his intuition correct, he conducted an experiment involving 100 students at MIT's Sloan School of Management. Here're the results of the experiment:

  • Internet-only subscription for $59: 16 students.
  • Print-only subscription for $125: Zero students.
  • Print-and-internet subscription for $125: 84 students.

As expected, MIT's students were quite rational and nobody choose the second option. But were they influenced by "the decoy" or not?

The answer came with a second experiment involving a different group of students, which would simply remove the second option. The results clearly showed that, yes, the students of the first experiment were fooled by the presence of the decoy. Here are the second experiment's results:

  • Internet-only subscription for $59: 68 students.
  • Print-and-internet subscription for $125: 32 students.

The results are distinctly showing the effect of the decoy on the students of the first group. They also reveal the intent of the magazine marketing strategy: using their behavioral psychology skills to their advantage, consequently pushing up subscription revenue.

Action bias and investment decisions

Even if the method intended to divert customers' attention from a more favorable option to the most lucrative one in a multiple choice setting by creating an easy and relative choice, the decoy effect is widely used also in its binary version.

What I mean is that people don't necessarily need to provide a lot of options if they want to fool someone into doing something which would benefit them. They can obtain the same effect with two options, especially if they can avoid providing the most convenient option to the customer.

The only ingredient they need to add to the offer is, for the customer, the willingness to choose between one of them (as opposed to refuse both options). In order to do that they can, specifically, work on another type of brain wiring: the action bias, which can be defined as our tendency to favor action over inaction. This is a very powerful bias, and is widely used in the investment business to force people to perform any kind of choices (except the ones that benefit the customer itself).

If you combine a binary choice containing a decoy with the action bias effect, the result is a person who feels the urgency to act without having a rational reason to do it.

Here are three examples of how we could easily get hooked (either by others or by ourselves) if we don't pay enough attention.

1. An investment website posting articles with a title like: "X vs. Y, which is the better buy?"

A person reading the article will feel that one of the two companies has better chances of producing satisfying results: it could have better profitability, less debt, better margins, etc, but the right question to ask is: Do any of the stocks provide an adequate margin of safety at current market prices?

Here, the trick is that of attracting the reader (either in order to increase page views or to promote a specific stock) based on the natural willingness to act and suggesting that he can have a choice when there could potentially be no good choice at all. The decoy effect can be related to the fact that we're not comparing two companies which have slightly different characteristics, but one of them is a clear winner.

2. The price of a stock we would like to buy has recently risen significantly, giving the idea that it is now too expensive, so we are only willing to buy it at a lower price.

When the price corrects by 20 or 30%, we feel the urge to pull the trigger as, compared to the peak price, we think we're getting a discount (someone could tell us that this is a stock to "accumulate on dips").

As we don't have a clear idea of how much the company is worth, we're using our natural attitude to make easy comparisons to determine how and when to act. That's why, for example, a lot of people bought GameStop (

GME, Financial) stock at crazy prices on the way down from its January and March peaks. Nobody wants to miss the boat (action bias) and at the same time they feel they've a simple choice in front of them (the no-brainer is: the price is much lower than it was at its peak). Of course, most people don't see that the best choice is not to choose.

3. An investment adviser sends an email with two to three options to choose from.

It could be a shiny initial public offering subscription, a bond fund providing higher returns to your adviser than to yourself or an equity fund based on biotechnology stocks your adviser doesn't know anything about.

Here the action bias is working in your adviser's favor, increased by the idea that you "need to plan for your future" and the fact that he provides several choices in which there's a clear winner (in terms of return) while the others are pretty boring provides the decoy effect. In this specific case, the function of the decoy is not that of making us overlook one of the options (as most probably the right choice is not being offered to us), but simply that of orienting us toward the clear winner.

The list could go on and on, but the mechanism is pretty much the same: we prefer to make relative (and easy) choices and our brains are craving for action. For this reason, we should not be surprised to learn that some of the best investors realized it early on and tried to create an environment that would shield them from the continuous flow of incentives, and possibly far from the temptations of Wall Street.

Conclusions

As previously explained, the investment world is filled with people trying to use our psychological biases in order to force us to act irrationally. Furthermore, because of our nature, we often end up being both victims and perpetrators at the same time.

When we have multiple choices, we tend to focus on the two which are easily comparable, and happily ignore all the rest. On top of that, our natural inclination to act as opposed to doing nothing may produce an irresistible urge to do the wrong thing at the wrong time.

Being aware of these (and other) mental pitfalls can help us to remain rational and make the best choices for us, our family and our clients.

Disclosure: The author does not own shares in any of the mentioned companies.

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