Nudging people in the right direction
You’re probably not surprised to hear humans don’t always make the best decisions. If we acted rationally, we’d eat a healthy diet, exercise regularly, spend less than we earn and invest the difference. Unfortunately, traditional economic theory ignores this reality and assumes we all make rational decisions. The recipient of this year’s Nobel Prize in Economics, Dr. Richard Thaler, is one of the pioneers of connecting economic theory with actual human behavior.
Besides demonstrating why people don’t consistently do most of these activities, Thaler’s work has been instrumental in identifying methods for making better choices. In the book “Nudge” he co-wrote with Cass Sunstein, Thaler explores a number of areas where our typical behavior is counterproductive to our long-term goals.
For instance, one tendency people have is to stay with the default option due to inertia or lack of understanding of the available choices. This is common with retirement plans when a new employee has to decide whether to participate or not.
Thanks to the work of behavioral economists, many companies now automatically enroll people in the retirement plan as the default option which has dramatically increased the participation rate of employees. Employees can always opt out but since the default is to automatically contribute, most people don’t choose to cancel their participation.
One weakness with this default option is the amount people are automatically contributing is often still too low to adequately save for retirement. In other words, if your employer has an automatic enrollment feature of 4 percent, it’s a good start but you’ll still need to raise the contribution amount if you ever want to stop working.
To overcome this particular issue with insufficient savings rates, some companies have adopted another principle of behavior finance dealing with our aversion to loss. While you may agree it’s important to save more, you’d rather wait until later because you need all your income now. By tying the increase in contributions with your next raise, you won’t see your actual take-home pay decrease.
In a perfectly rational world, none of these programs would be necessary as everyone would calculate the amount they need to save and then consistently save that amount each month. As we all know, humans are anything but rational so devising methods to harness our innate tendencies is one of the keys to financial success. Thaler’s work in connecting psychology with economics has been instrumental for better understanding the behavioral obstacles we often face without even knowing it.