In their 2008 book Nudge, researchers Richard Thaler and Cass Sunstein distinguish between two types of individuals: humans and Econs. Econs are “these strange creatures” found only in economics textbooks. They are unemotional, smart and never have self-control problems. Humans, by contrast, are the type of people we interact with every day. They are emotional, prone to making mistakes and rarely act on full information.
Classical economic models typically assume that we live in a world of Econs, not humans, as these economic assumptions and theories are based on the idea that individuals always make prudent and logical decisions to maximize their self-interest. Long before Nudge was published, researchers began to question this rational-actor model, focusing on how people actually think and make decisions. Behavioral economics recognizes the role of emotion and intuition in decision making and considers the psychological barriers that often prevent people from making perfectly rational choices. Behavioral finance maps this information to the design of financial products, processes, and systems.
The Beginning of the Behavioral Revolution
Behavioral finance largely got its start in the early 1970s by Daniel Kahneman and Amos Tversky, two psychologists who felt that the rational-actor model was too optimistic. Their 1974 paper, Judgment Under Uncertainty: Heuristics and Biases, examined how people make less-than-rational decisions in situations involving uncertainty.
The authors found that people rely on heuristics, or mental shortcuts, to help them reduce complex tasks of assessing probabilities and predicting values to more manageable judgmental operations. While these shortcuts can be useful, sometimes they lead to “severe and systematic errors.” Many of the cognitive biases Kahneman, Tversky and other researchers have identified are ones that you know by now, such as confirmation bias, the tendency to be drawn to information that validates existing beliefs, or recency bias, the tendency for people to believe what’s happened recently will continue to happen. Another is mental accounting, which occurs when a person views various sources of money as being different than others.
In 1979, Kahneman and Tversky developed prospect theory, a critique of expected utility theory (the assumption that human beings make rational choices based on the utility of the outcome of the decision). In the classical model – think, the one where Econs and not real people with emotions make the decisions – two outcomes with the same expected utility will be given the same preference by rational decision makers. But Kahneman and Tversky demonstrated that the outcome of decision making under conditions of gains and losses is not symmetrical. For example, they found that people have a strong preference for certainty and would rather lock in a sure gain over the reasonable potential to gain a larger sum, thereby demonstrating risk-averse behavior, yet that these same people tend to give losses more weight than gains and engage in risk-seeking behavior when faced with the prospect of limiting losses. This idea, called loss aversion, simply implies that people weigh losses more heavily than gains. Prospect theory explains, for example, why investors hold on to losing stocks for too long and sell winning stocks too soon. For his work in developing prospect theory, Kahneman became only the second psychologist to win the Nobel prize in economics.
Applying Behavioral Finance
Understanding the cognitive biases that lead to regular less-than-rational decisions can help scholars and policymakers guide individuals towards better choices. If you have been employed by an institution that automatically enrolls new employees into a retirement savings plan unless they opt-out, the University of Michigan among them, then you have experienced this guiding hand.
The automatic enrollment provision of 401(k) originated in research by Richard Thaler of the University of Chicago and Shlomo Benartzi of UCLA. Dubbed “Save More Tomorrow” (“SMarT”), the program sought to tackle a well-known problem: a substantial proportion of employees do not participate in their company’s defined contribution retirement plan, even when that means they forego matching funds (free money) from their employers. The program worked because it circumvented the psychological factors that prevent employees from enrolling in their employer’s plan, such as inertia, loss aversion, and immediate gratification.
SMarT allows employees to pre-commit to increase their saving rate in the future. Moreover, for the employees who do participate in the program, their first increase in savings coincides with a pay raise so that take-home pay does not decrease. This characteristic of the program avoids triggering the mind’s hypersensitivity to loss. The contribution rate increases with subsequent pay raises until a ceiling is reached. Inertia works in employees’ favor here, as employees do not have to take any affirmative steps to continue to increase their contribution rates.
The first case study involving SMarT showed that employees at a midsize manufacturing company increased their contribution to their retirement fund from 3.5 percent to 13.6 percent of salary over a three-and-a-half-year period. The program is now offered by more than half of the large employers in the United States, and a variant of the program was incorporated in the Pension Protection Act of 2006.
In Nudge, Thaler and Cass Sunstein expanded on the idea of overcoming the psychological barriers that influence people’s decisions (or lack of decisions) by tackling choice architecture — the design of the environments in which people make choices. Choice architects are people who influence the way people choose. Since choice architects must choose something, why not use psychological insights to “nudge” people towards making better decisions?
Take retirement saving, again. Many people simply do not enroll in a retirement plan, even after being presented with educational materials and retirement-planning seminars. (We are assuming they paid attention and learned something from the materials/seminars.) Thaler and Sunstein found that if the default option is that employees must affirmatively opt-in to a retirement savings plan, people are less likely to take that step to enroll. But if the default is to have to opt-out of the plan, employees are more likely to remain in the plan rather than to take an affirmative step to get out of it. It is important to note that employees still have the option of not being enrolled; they just have to work a bit harder to un-enroll.
Choice architecture and these other nudges are the basis for Bank of America’s “Keep the Change” program as well. In short, this checking account helps customers change by rounding up every purchase they make to the nearest dollar and automatically depositing that change into the customer’s savings account. Were you going to save $50 in a month by yourself? Maybe not. Will you use your debit card 50 times in a month? You might. Voila! $50 saved. Other banking programs and even smartphone apps like Acorns and Folio, for example, help consumers overcome inertia and their own timidity to take the plunge into the stock market by investing their spare change.
On the flip side, choice architects can intentionally take advantage of our cognitive biases to encourage unwise financial decisions. One example relates to credit card minimum payments and anchoring bias. The minimum payment simply represents the amount that a cardholder must pay each month to stay current on her account and to avoid fees and penalties. Despite the high interest rates associated with credit cards, and that credit card companies have calibrated their minimum payment formulas in order to drag out the repayment period, many Americans pay close to only the minimum amount each month. But why?
Two economists surveying millions of credit card accounts between 2008-2013 found that the minimum payment acts as an “anchor” by influencing how consumers view their ability to repay their debt. By being featured prominently on a credit card statement, largely in comparison to the total amount due, the minimum payment acts as a reference anchor for consumers who can theoretically pay back any amount over the minimum they choose. Moreover, by paying the minimum, consumers continue to be in good standing with their lender and avoid any fees or penalties. One study showed that people who had their minimum payment figures hidden increased their payments by 70 percent. An issue at play here is how policymakers can create a framework that balances the interest of consumers and, in this case, credit card companies. One example of action in this area is the Credit Card Accountability Responsibility and Disclosure Act of 2009 (“CARD Act”), which included several provisions designed to make credit card pricing fairer and more transparent.
Although Dr. Kahneman began to turn traditional economic theory upside down nearly forty years ago, it is only within the last couple of decades where researchers, policymakers and managers in the private sector have taken behavioral insights and applied them more broadly to understand and optimize behavior. Successful but limited applications of behavioral finance, like the SMarT program to retirement saving, suggests that there is a great deal of work to be done to figure out where behavioral finance can most appropriately be applied. Indeed, “the big challenge,” as MIT economist Antoinette Schoar has noted, “is to know the realm of applications where these heuristics are useful, and where they are useless or even harm people.”
Critics of behavioral finance argue that nudging people to make “better” choices is a form of elitist paternalism, or that sometimes it’s hard to tell a nudge from a shove. But researchers in this field reply that better choice architecture guides people to make choices they themselves know to be better. As behavioral finance continues to move outside the experiential and be applied by policymakers and managers in real-world settings, now is a good time to explore where behavioral finance has come from and where it might go from here.
Interested in attending the Behavioral Finance Symposium co-hosted by ideas42 and the University of Michigan’s Center on Finance, Law, and Policy on September 14-15, 2017? Register here!