Do you know if your decision makes a difference? Do you know which one is better for you?
Nudge is a book grounded in economics, which means it argues incentives are a powerful tool for shaping human behavior. Nudge is also a book ground in psychology, which means it does not assume that people always see incentives or fully understand their implications.
The New York Times reports on an interesting example of these two points: Debit cards that require either a customer signature or a PIN number. Different companies involved in the payment chain have conflicting preferences about which ones customers should use. Customers, of course, have their own preference — the debit card that leads to the lowest overall price for whatever product they are buying. The problem is that most don’t know which card that is.
Investors with an “overconfidence” bias often trade too much and manage their portfolio on a stock-by-stock basis—while assuming they can beat the market, which the University of Chicago’s Mr. Thaler says probably won’t happen.
Mr. Thaler recommends a little test for the presence of an overconfidence bias. “Write down 10 traits [such as ‘investment skill’ or ‘ability to make good stock picks’], then ask yourself how you rate compared to your co-workers. If you rate yourself above average on all of them, plead guilty,” he says.
In Australia, superannuation is a long-term savings and investment vehicle that, like the 401(k) in the U.S., provides tax-advantaged retirement benefits for individuals. Since summer 2005, a overwhelming majority of Australian workers have been able to choose an investment fund through superannuation. (Prior to 2005, fund selection was largely made by a trustee of some kind.) With more than 200 fund options to choose from, investors have been overwhelmed. (Just think how overwhelmed they would have been if they had lived in Sweden where a privatized version of social security yielded almost 800 fund options!) In a new report on the policy, the Australia Institute levels some harsh criticism.
The fact that fewer than ten per cent of workers actively choose a fund should not come as a surprise. Indeed, as little as four per cent of workers switch super funds each year and around half of this is ‘passive’ choice due to job change or fund closure. Because participation is compulsory, a great many fund members, and particularly those a long way from retirement, do not take a keen interest in their super. Being automatically enrolled in a retirement savings system is not conducive to active consumer decision-making.
Choice of Fund has also been largely unsuccessful in lowering the number of multiple accounts, one of the most serious problems for superannuation policy-makers. In fact, the number of accounts per employee has actually increased, suggesting that choice has not ‘empowered’ consumers to take even the most basic action to improve their superannuation arrangements. Three years on, the failure to promote consumer-centred competition has resulted in considerable waste across the super system. Average fees levied by fund managers have not fallen, remaining at around 1.25 per cent of funds under management (equating to around one per cent of GDP), and significant fee and performance variations persist between not-for-profit funds and for-profit (retail) funds. Moreover, it is estimated that Australians pay around $2.4 billion a year in commissions on superannuation assets, including $862 million on their compulsory superannuation contributions. Financial outcomes for workers can vary considerably depending on the fund that their employer nominates as the default fund.
Read the full paper for six design principles for a default rule, including a somewhat controversial argument that default options should “focus especially on the needs of people who are a long way from retirement, or whose accumulated benefits are relatively modest,” because of the poor decisions that people make in situations where the effects are not felt until well into the future. Because of the complexity of investment decisions, and the number of amatuers among all age groups, the default rule should be issue No. 1 for a choice architect regardless of whether the employee is 23 or 63.
From former CBO director and soon to be Office of Management and Budget director Peter Orszag.
The overall share of 401(k) participants with 90 percent or more of their assets invested in company stock is more like .47*7.3=3.4 percent. It’s still too high…The good news is that the trend is towards less investment in company stock. For example, in 1999 EBRI estimated that 19.1 percent of all 401(k) assets were held in company stock…By 2006, that share had fallen to 11.1 percent.
The figure below, which shows this decline, comes from the Employee Benefit Research Institute. The company stock figures are the second batch of bars from the left.
From a new paper by Eldar Shafir, Michael Barr, Sendhil Mullainathan. Some of the highlights are below. OK, so they aren’t all behavioral economists. Mullainathan is. Barr is a law professor and Shafir is a psychology professor.
1. Full information disclosure to debias home mortgage borrowers.
Useful information that Shafir, Barr, and Mullainathan have in mind includes disclosing the borrower’s credit score, and the borrower’s qualifications for the all of the lender’s mortgage products.
2. A new standard for truth in lending.
We propose that policy makers consider shifting away from sole reliance on a rules based, ex ante regulatory structure for disclosure embodied in (the Truth in Lending Act) and toward integration of an ex-post, standards-based disclosure requirement as well.
We propose that a default be established with increased liability exposure for deviations that harm consumers…In our model, lenders would be required to offer eligible borrowers a standard mortgage (or set of mortgages), such as a fixed rate, self-amortizing 30 year mortgage loan, according to reasonable underwriting standards.
4. Restructuring the relationship between brokers and borrowers.
An alternative approach to addressing the problem of market incentives to exploit behavioral biases would be to focus directly on restructuring brokers’ duties to borrowers and reforming compensation schemes that provide incentives to brokers to mislead borrowers. Mortgage brokers have dominated the subprime market.
5. Using framing and salience to improve credit card disclosures.
See something like RECAP, proposed in Nudge.
6. An opt-out payment plan for credit cards.
Consumers would be required automatically to make the payment necessary to pay off their existing balance over a relatively short period of time unless the customer affirmatively opted-out of such a payment plan and chose an alternative payment plan with a longer (or shorter) payment term.
7. An opt-out credit card.
Consumers would be offered credit cards that meet the definition of “safe.” They could opt for another kind of credit card, but only after meaningful disclosure. And credit card firms would face increased liability risk if the disclosure is found to have been unreasonable.
8. Regulation of credit card late fees.
Under our proposal, firms could deter consumers from paying late or going over their credit card limits with whatever fees they deemed appropriate, but the bulk of such fees would be placed in a public trust to be used for financial education and assistance to troubled borrowers…Firm incentives to over-charge for late payments and over-limit borrowing would be removed, while firms would retain incentives appropriately to deter these consumer failures.
9. A tax credit for banks offering safe and affordable accounts.
Market forces weaken or break down entirely with respect to encouraging saving for low income households. This is simply because the administrative costs of collecting small value deposits are high in relation to banks’ potential earnings on the relatively small amounts saved, unless the bank can charge high fees; with sufficiently high fees, however, it is not clear that utilizing a bank account makes economic sense for LMI households.
10. An opt-out bank account for tax refunds.
Low-income households without bank accounts would have their tax refunds automatically deposited into a new account, similar to something like the SAFE-T account that residents could draw on. (H&R Block offers a similar product.)
Watch a video about the paper, sponsored by the New America foundation, below:
“I have not looked at any of my holdings and don’t intend to. I don’t want to be tempted to jump because I think I’d be more likely to jump in the wrong direction than the right one. My advice has always been to choose a sensible diversified portfolio and stop reading the financial pages. I recommend the sports section.”
Do comprehensive pictures of your finance help keep you out of debt? Guest blogger Julia Thomson thinks so. Online brokerage accounts often offer up-to-the-minute portfolio values, but Thomson has a much more comprehensive idea in mind, one involving all of someone’s assets and liabilities. Thomson is a former financial adviser, recently retired, who lives in Arizona with her husband, Gerald — “an Econ in the flesh,” she says.
Jay Ritter, the Cordell Professor of Finance at the University of Florida, sends some thoughts along in response to a piece about financial literary in this week’s Economist that features Nudge. Even professors of finance need a nudge sometimes!
1) I remember in 1990 or so telling a fellow finance professor that I didn’t really know how to do the lease vs. buy decision for an auto purchase. (Once I started teaching leasing, I figured this out.) He admitted that he didn’t know either.
2) And I remember how my first wife, with an MBA from Michigan, didn’t understand the basics of how to minimize interest payments on credit cards (pay off one in its entirety each month, and charge current purchases to that card, so that we didn’t have to pay interest immediately on each new purchase).
3) Last October I advised my brother, a successful small businessman, on taking out a mortgage. He didn’t realize that the implicit interest rate that he would be paying was over 33 percent per year on the monthly cash payment saving if he took out an interest-only mortgage. I was able to figure this out quickly, but I knew it had to be a high number because of the adverse selection problem that exists with the consumers who are taking out interest-only mortgages. His mortgage broker probably couldn’t have figured this out, even if she had the correct incentives to do so.
We have long advocated automatic enrollments in 401(k) plans as a way to help people save more for retirement. We (along with others) have produced research showing how poorly most people make investment decisions, either by naively diversifying, by chasing past performance, or by loading up on company stock.
As more companies adopt automatic 401(k) enrollment thanks to new congressional law, individual investment decisions (and biases) will become even more important. In today’s New York Times, benefits consultant Ted Benna says teaching people personal finance has been a tougher challenge than many financial advisers originally thought. “When 401(k)’s started, he said, ‘we thought we could educate most people to manage their retirement accounts.’ But as it has turned out, most people prefer a ‘set it and forget it approach,’ for which target-date funds are ideal.”
Target-date funds are ideal for younger investors and those without large retirement nest eggs. Rather than use a single form that requires individuals to choose individual mutual funds for their portfolio, should companies use two forms – a basic default form and an advanced form. After filling out basic demographic information, the basic form would ask one question: At what age, approximately, do you plan to retire? Individuals would be enrolled in the appropriate target-date fund based on their answers. More advanced investors could choose the form that allows the flexibility in picking funds.
The possibilities for great nudges are everywhere. (For a list of favorites from the book, check out our dozen nudges.) We invite readers to send their own nudge suggestions to nudgeblog@gmail.com.
The Nudge blog is associated with the book Nudge: Improving Decisions about Health, Wealth, and Happiness, by Richard Thaler and Cass Sunstein. Sunstein is currently the Administrator of the White House Office of Information and Regulatory Affairs and has no affiliation with the Nudge blog.
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