Is Gamification Bad for Investors?
We encourage the SEC to figure out which nudges and conflicts are problematic and avoid sweeping changes that could stifle savings.
The paradox brought about by digital trading platforms is that digital nudges, also called behavioral prompts, have the potential to both aid and hinder investors. Nudges can positively influence investors by encouraging behaviors--like saving--that benefit investors and serve their personal goals.
Commenting at the recent SEC Speaks conference, Chair Gary Gensler pointed out that "digital platforms … have enhanced the user experience and brought greater retail participation into our markets." Certainly, new applications such as Robinhood have become very popular, particularly with younger investors. But Gensler mixed his praise with a note of caution, as he highlighted the SEC's concern with digital nudges and mulled over whether these nudges should be regulated.
Gensler expressed worried that digital platforms may use nudges opportunistically "to encourage more trading because [the broker] would receive more payment from those trades." The SEC outlined some concerns in a recent Request for Comment on digital platforms using nudges.
Morningstar submitted a comment letter suggesting how to specifically address certain types of nudges. Successful regulation of nudges would preserve their benefits yet soften their dangers. It is clear that some types of nudges induce investors to save. But nudges can also lead to investor behavior that has negative consequences, such as causing investors to partake in risky trading activities. Since nudges can have such differing effects depending on how they are used, regulating them with broad strokes and bright-line rules is challenging.
For example, on the positive side, the nudge to default investors into savings plans is one of the most powerful techniques that America has for helping people save for retirement. When a retirement plan's mobile app defaults investors into an automated savings plan, it steers investors into decisions that will likely benefit them with a larger retirement savings account for the long term.
By contrast, the SEC should be concerned about nudges that default investors into margin accounts on trading apps. When trading apps default investors into margin accounts, the default could cause investors to engage in risky margin trading, which may harm less-informed investors. Defaulting customers into margin accounts without first accounting for their investment purposes exposes them--perhaps unnecessarily--to the additional risks that come with margin accounts, such as the possibility that the broker could halt trading from their margin accounts during situations of high market volatility. This risk was vividly illustrated by the events surrounding the trading of GameStop stock in January 2021.
On the flip side, just-in-time disclosures, another type of nudge, have been found to be particularly helpful to investors. Just-in-time disclosures inform investors of pertinent risks at the time of making an investment decision, such as trading in a volatile market. These disclosures provide information on the relationship between selling during a sudden downturn and long-term portfolio effects, and they have been found to be most effective when given before a sell transaction is executed. Robo-advisor Betterment pioneered a nudge that successfully discouraged overtrading with a just-in-time disclosure that reminded people of the tax consequences of such trades. That nudge helped people direct attention to where it was needed and slowed down an otherwise hasty process. Notably, just-in-time disclosures could be implemented to notify customers of the impact of margin trading just before they trade, balancing out the nudge of being defaulted into a margin account.
Gensler called attention to conflict-of-interest issues posed by trading apps and their nudges. One common conflict arises when a broker has an interest in motivating frequent trading because the broker receives payment for data sharing or order flow. Another conflict may exist when a robo-advisor does not charge a fee but allocates a high percentage of the investor's portfolio into cash reserves. In the first case, the customer thinks the trade is free but is paying through a higher price or other costs. In the latter case, the investor may be better off if the robo-advisor had simply charged a management fee instead of generating profits from high cash allocations.
These behaviors aren't bad for investors, but investors should be free to choose the way in which they want to compensate investment professionals for the ability to trade or have their money automatically invested. The problem lies in customers thinking a service is free when it is not because of less transparent, second-order costs and not being aware that the financial institution has interests at stake that are at odds with the customer.
Regarding self-directed accounts, although Regulation Best Interest does not apply, broker/dealers should be required to disclose all relevant conflicts to their clients. Investors should receive a very brief, easily understandable conflicts disclosure, so investors can meaningfully compare brokers and make informed choices. In the case of robo-advisors, customers should be aware that when they do not pay a management fee, they pay in the form of a lower return through a higher cash allocation in their portfolio.
We encourage the SEC to carefully discern which nudges and conflicts are problematic, rather than making sweeping changes that could stifle engagement, innovation, and saving. Innovation by market participants has prompted significant engagement in markets, and digital engagement practices have played a key part in that progression. That being said, self-directed or not, investors need to know the conflicts at play when they are being nudged.