Why Nudging is Good for You and Your Money

October 20, 2017

 A few weeks ago, Richard Thaler, the founder of Behavioral Economics, was awarded the Nobel Memorial Prize in Economic Sciences for his research on human behavior. What’s so groundbreaking about Thaler’s research is that it acknowledges the irrationality of human-decision making in the context of Economic theory which, historically, has assumed perfectly rational behavior. As it turns out, this irrational behavior is all around us. When we buy something because it’s on sale even though we don’t want it, we’re engaging in irrational behavior. When we treat money won at a casino differently from money earned at a job, we are contradicting rational economics. Human error is all around us and plays a significant role in all areas of our decision-making including when it comes to how we approach our money.

 

When the news came out that Thaler had finally won the Nobel Prize, you probably saw a variety of headlines featuring the word “Nudge.” Nudging is the idea that there are things we can do when it comes to presenting information and forming policy that can encourage individuals to make better decisions and was the topic of a book Thaler published nearly a decade ago. In the book, he explores how behavioral science research can be used to build “choice architecture” that “nudges” individuals toward a more “economically rational” decision without limiting their freedom. It’s a tricky topic to be sure. People don’t like to have their freedom limited, especially here in the US. We pride ourselves on individualism and freedom of choice. We don’t want our government, or anyone else for that matter, telling us how to live our lives and what choices we ought to make. Unfortunately, a byproduct of that freedom is that, as present-minded individuals, we often fail to adequately prepare for the future. Roughly 20% of Americans age 65 and older rely on Social Security to provide over 90% of their income in retirement. Social Security was never intended to be the primary form of retirement savings for Americans but it is, in large part, because we struggle with saving now for our future retirement.

 

In his most recent book, Misbehaving, Thaler devotes an entire chapter (and then some) on using behavioral science to “nudge” individuals to do a better job at saving for the future. One of the ways he has attempted to do this is by reframing the way individuals chose their corporate retirement benefits. Instead of having individuals opt into a savings plan at the companies he is working with, they now have to opt out. Instead of checking a box that says, “yes, I would like to contribute to my 401k” individuals have to check a box that says, “no, I would not like to contribute to my 401k.” As it turns out, most of us are irrationally disposed towards not checking a box – we prefer to maintain the status quo. We don’t want to be proactive about our savings choices. We want to be passive. If however, we can be “nudged” to choose to contribute to a retirement savings account, albeit even if it’s a “passive” choice, we will be better off in the long run. In addition to reframing 401k enrollment from a default opt-out to a default opt-in, Thaler also pioneered the Save More Tomorrow approach which we’ve written about in the past (see article).

 

In another study, Thaler and his colleagues found that a change in the frequency with which investment performance on retirement savings accounts are reported affects how individuals invest. When investors are shown performance over a longer period of time (a year versus a month) they trade less often and are less prone to shifting money into funds with “high recent returns.” Trading often and chasing returns is known to lead to underperformance. By presenting performance over time and thereby allowing day-to-day fluctuations time to smooth out, irrational human investors are nudged towards avoiding panic-driven investing decisions. 

 

One final example of “nudging,” one which Thaler terms as his “most famous example,” is the fly in the urinal. In an effort to get men to pay more attention to where they aim while using the restroom, the Schiphol International Airport in Amsterdam installed urinals with an etched image of a housefly near the drain. Following their installation, airport management noted a reduction in “spillage” by roughly 80%. In response to this example, Thaler writes, “for me, that fly in the urinal has become the perfect exemplar of a nudge. A nudge is some small feature in the environment that attracts our attention and influences our behavior.”

 

When it comes to your money, good decisions matter. Over the course of a lifetime, the very basic decision to participate in a 401k plan can have a significant impact on your later years. Maxing out your retirement savings may mean the difference between retiring when you want to or having to work until you’re 70. At Cedarstone, we believe there’s more to wealth management than just the math. Everything we do, including writing these articles, is done to encourage our clients to make good decisions and succeed in the financial arena. Whether that means staying the course in your portfolio or setting up a Roth account to save on taxes, our aim is to help you to make rational decisions now for the sake of your future goals. If there’s anything we should take away from Thaler’s research, it’s that we are imperfect decision-makers who need a little assistance now and then, and while that’s humbling it’s not without hope. The more we learn and the more we scrutinize our own behavior, the more we increase our chances of making smart decisions and setting ourselves up for success.

 

“People Aged 65 and Older Who Rely on Social Security fo 90% of Family Income (in 2013) and Average Monthly Benefit (December, 2014) by State.” AARP Public Policy Institute. November 12, 2015. https://www.aarp.org/ppi/info-2015/people-aged-65-and-older-who-rely-on-social-security-for-90-percent-of-family-income-and-average-monthly-benefit-by-state.html.

 

Thaler, Richard H. Misbehaving. New York: W.W. Norton & Company Ltd., 2015.

Share on Facebook
Share on Twitter
Please reload

Recent Posts

January 3, 2020

Please reload

Archive
Please reload

Related Posts
Please reload

DISCLOSURE Information on this website and others should be used at your own risk. Past performance does not guarantee future results. Securities investments involve risk; returns in such investments vary and may involve gain or loss. The materials and content herein are not a substitute for obtaining professional tax, personal financial planning, or other relevant financial advice from a qualified person or firm. For full disclosure click on the disclosure link at the bottom.

Subscribe to our Weekly Newsletter

2945 Townsgate Road Suite 200

Westlake Village, CA 91361

+ 888-571-5582

help@cedarstoneadvisors.com

Send Us a Message