What are financial nudges? How can financial nudging help people improve their lives?
Financial nudges are used for savings, investing, and borrowing decisions. These encourage greater savings, improved returns, and less bad debt.
Read more about financial nudges and how they can help you.
What Are Financial Nudges?
Most economics research focuses, unsurprisingly, on people’s economic choices—what they choose to consume, how they decide whether to spend or save, and which financial products they use. As noted above, however, economics treats people like infallibly rational Econs, fictional beings who all know the tradeoffs of variable-rate vs. fixed-rate loans and always make their credit-card payment on time.
Libertarian paternalism, oppositely, treats humans like Humans: beings that occasionally need financial nudges to make the best money decisions for themselves.
Financial Nudges to Increase Saving
A troubling economic trend among contemporary Americans is the declining savings rate. (In 2005, thanks to abundant, cheap credit and low interest rates, Americans spent more and the American savings rate was actually negative for the first time since the Great Depression.) Given the ever-growing strains on the Social Security system, which is likely headed for insolvency, Americans will need to save more themselves to enjoy a comfortable retirement. But how do you get people to save more without infringing the principles of economic liberty? Financial nudging.
Thaler and Sunstein propose two financial nudges: automatic enrollment in savings plans and a new savings vehicle, the “Save More Tomorrow” program.
Nudges to Improve Investing
Not very long ago, the most common retirement plan offered by employers was a “defined-benefit” plan—that is, one that made fixed payments to the beneficiary based on tenure and salary. Now, the most common type of retirement benefit is a “defined-contribution” plan, which consists of contributions made to a tax-sheltered investment account.
With this shift has come a greater decision-making burden on workers. What level of risk am I willing to take, and how do I allocate my savings accordingly? Should I be investing in stocks or bonds or both? How often should I revisit my allocation of assets, and what real-world information should I be looking for to know when to change it?
If we were Econs, we would have no trouble (1) recognizing that stocks outperform bonds historically and (2) calculating our tolerance for risk based on the probability distribution of stock-market returns. But, because we’re Humans, the complexities and variability of defined-contribution plans tend to bring out harmful cognitive biases that end up—quite literally—costing us.
One cognitive bias that is especially common when it comes to investing is loss aversion (see Chapter 1), which results in overreactions to short-term market fluctuations. For example, Humans will fixate on the monthly, weekly, or even daily movements of the market and potentially change their asset allocations on those bases—when, in fact, these fluctuations belie the long-term upward trend of the market. Case in point: A study of retirement plans administered by Vanguard showed new enrollees allotting 58% of their account to stocks in 1992, 74% by 2000 (when tech stocks were booming), and 54% by 2002 (after the tech bubble burst). In other words, these employees bought high and sold low—the exact opposite of what they should have done.
Humans also tend to resort to rules of thumb when it comes to investment decisions. One such rule is “When in doubt, diversify.” But “naive diversification”—e.g., splitting your asset allocation 50/50 between stocks and bonds; or, when faced with more than two options, dividing your money up evenly between the several choices—can be just as detrimental to your retirement account as loss aversion. For example, if you divide your assets equally among three bond-heavy funds and one that’s split 50/50 between stocks and bonds, your investments actually aren’t diverse—you’re overallocated to bonds. Financial nudges can increase information on investing, too.
(It’s important to note that, overall, diversification is a good thing. Take, for example, investing in your own company’s stock: Economist Lisa Meulbroek found that a dollar invested in company stock is worth less than 50% of a dollar invested in a mutual fund! Enron and WorldCom employees who poured their retirement savings back into company stock learned this lesson the hard way.)
Financial Nudging to Improve Borrowing
From mortgages to student loans to credit cards, Americans are some of the most indebted people on the planet. Yet most people have no idea what kinds of risks they’re taking on when they borrow. Financial nudges can help people understand risk and make more informed choices.
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Like what you just read? Read the rest of the world's best summary of Richard H. Thaler and Cass R. Sunstein's "Nudge" at Shortform .
Here's what you'll find in our full Nudge summary :
- Why subtle changes, like switching the order of two choices, can dramatically change your response
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- The best way for society to balance individual freedom with social welfare