Mistaken beliefs & Nudges: Nothing Mutual
All of us have seen the 'Nudge' advertisement for Mutual Funds; it takes many forms but the consumers feel the nudge stemming from an advice, more of a persuasion from a seemingly more informed friend or an associate.
When Financial literacy is extremely low, a nudge of this kind would help to stimulate some thoughts in the direction of trying an alternate path not taken earlier. It could at the least persuade a fellow to look up what mutual funds are all about and whether investments in these funds could make one better off or worse off in the short or the long run.
The Nudge could have been the other way as well, for example in this case there could be a nudge for staying with low return fixed nature of return portfolio, especially for those who do not have financial literacy at all. It would make great sense to save the fees charged in this case.
The markets for information on the other hand is weak, if information could be priced such that it could be linked with return, it would have been the most efficient. For example if I would have the option of spending more for a higher return, I would do so. This would manifest as a high return Mutual Fund charging higher fees (cost of information) being approached as a natural corollary. But data has shown that those charging high fees have actually not given higher returns in the past as again this is an example of market failure for information; charging high fees is a matter of market power, not necessarily this could guarantee higher returns.
If everyone would be staying in the low cost zone, choosing from those funds who charge less, it could well be that these funds would be ending up keeping their low return promise through a fixed debt structure. The default structure of these funds is a guard against costly wrong-decision.
A further corollary would be to self-invest in low risk funds and gain from the lack of fees as well. Ignoring a nudge for the costly option in this could well be the best option if one is satisfied with a default structure of return.
The market structure for high returns funds is different. It is somewhat structured around mistaken beliefs.
Taking a risky path where not even the principal is guaranteed while you are paying a high fee for taking a high risk falls in the domain of what economists call, mistaken beliefs of how financially literate one is.
There are two types of mistaken beliefs, one that you consider yourself financially literate, whereas you are actually not and the second that you do not actually know that you are actually literate or not.
In both these cases you are prone to react to nudges that would take you in a direction where you could rely on a market structure that could end up delivering a return that neither was promised nor is acceptable to you.
The default structure of mutual funds is built on well diversified low cost structure, whereas the risk prone area is filled with high cost, low performing alternatives. Those misunderstanding the choices are those who felt the nudge more as they fell in the category of 'mistaken beliefs' about their financial literacy.
The Swedish Case study as developed in this brilliant NBER paper gives us a glimpse of the trade offs and the market structure of mutual funds that are built on the nudges and mistaken beliefs. For retirees and pension holders, the country used a nudge to help them understand the low risk, low return funds better.
India is a developing country and particularly not high on financial literacy; the least we can do is help pension holders and retirees to understand the nuances of investing in a risky portfolio.
We therefore need nudges like the Swedish did, give as much information to retirees on investing in a default structure, this way you can be sure that those who do not have the mistaken beliefs and know that they are financially illiterate, would not suffer.
Diploma in Mechanical Engineering 🧰
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