Behavioral finance combines psychology and financial economics. It is grounded in insights for which Daniel Kahneman, a psychologist, was awarded the 2002 Nobel Memorial Prize in Economics. Kahneman and his colleague, the late Amos Tversky, were fascinated by “mistakes” many people systematically make around judgments and decisions, because of fundamental psychological factors. The focus of behavioral finance has been on how psychology, the “human element,” often leads people into “money mistakes” when making decisions in the realm of finance.
This relatively young field is moving into an important new phase. We can call the first phase Behavioral Finance 1.0, which was an effort to understand why people tend to make the money mistakes they so often do. In other words, what is the underlying psychology? The goal of the new phase, Behavioral Finance 2.0, is to use this knowledge to help people avoid mistakes and make better financial decisions. Behavioral Finance 2.0 is behavioral finance in action.
WHAT IS BEHAVIORAL FINANCE 1.0?
One of the most important sets of financial decisions people make in their lives is planning for their retirement. Whether an individual elects to enroll in a retirement plan, how much they decide to save, and how wisely they invest all determine whether their “golden years” are indeed golden. The alarming reality is that most people make poor decisions around retirement planning and face a dramatic drop in their living standard when they stop working. Some of these poor decisions, which are important money mistakes, illustrate what behavioral finance is.
In the United States, about a third of workers with access to an employer-sponsored retirement saving plan, such as 401(k)s, fail to join the plan. By failing to save for retirement, millions of American workers forgo the tax benefits associated with 401(k) plans and (where it applies) the matching contributions offered by employers.
Evidence from the United Kingdom is even more puzzling as certain defined benefit plans don’t require employees to contribute anything at all. All employees have to do to benefit is to sign up. Remarkably, half of the eligible workers fail to join a retirement program that is totally free to them and fully funded by the employer.
The alarming reality is that most people make poor decisions around retirement planning
It’s not that workers don’t want to join a retirement plan in most cases. Quite the opposite is true. Research shows that most want to join, and often say they intend to do so, “in the near future.” One study found every single employee who attended a financial education seminar declared his or her intention to start saving for retirement, soon. Yet, only one in seven followed up on their good intentions within three months (Choi et al., 2006). Given the dramatic disconnect between good intentions and actions to fulfill those intentions, I argue that millions of employees around the globe are making a money mistake by not saving for their future.
Let’s review how behavioral finance can explain why people often make such money mistakes – decisions that are against their best interests. Three important psychological factors that lead people to make money mistakes are inertia, myopia (or “present bias,” as it is often referred to), and loss aversion, which refers to the observation that most people are hypersensitive to losses: we feel the pain of a loss of a given size much more than we feel the joy of a gain of the same size.
In the case of failure to enroll in a retirement plan, our interest is in inertia, a powerful psychological force that readers will recognize in their own lives. Inertia, also known as “status-quo bias”, is psychological resistance to change, and it affects a lot of our decisions (or lack thereof).
Inertia is related to the behavioral principle of cognitive laziness, or the desire to minimize thinking costs whenever possible.
Herbert A. Simon, the first psychologist to win the Nobel Prize in Economics, stressed the role of the minimization of cognitive effort in decision making. THE ROLE OF INERTIA
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The powerful role of inertia can be seen in a literally lifesaving domain, that of organ donation. Twelve percent of Germans make their body organs available for donation upon death. Given that information, I would like you to estimate the percentage of neighboring Austrians who donate their organs. Since guessing the precise number is almost impossible, instead, guess how low and how high it might be. That is, provide a range for what that percentage might be.
Most people who do this exercise guess that somewhere between 10-20% of Austrians make their organs available for donation when they die. People tell me that they base their estimate on the fact that since Austrians are neighbors of Germany and are culturally similar, they are likely to have similar donation rates.
Well, believe it or not, 99.98% of Austrians make their organs available for donation upon death! And, no, there is no typo in the number. Put differently, out of 10,000 Austrians 9,998 are donors and only two are not. By comparison, out of 10,000 Germans, 1,200 are donors and 8,800 are not. What can explain such a dramatic difference in behavior between neighboring nations? (Johnson and Goldstein, 2003.)
The default option and effective consent rates
Yes, you guessed it right: inertia. Organ donation in Germany is an opt-in, or explicit consent, system. People have to actively sign up to be a potential organ donor at death, and those who take no action are assumed non-donors. In other words, the default setting in Germany is non-donor. In contrast, the Austrian system is an opt-out, or implicit consent, system, where everyone is assumed to be a donor, unless they actively opt-out. The default setting in Austria is to be a donor.
According to standard economic theory, defaults should have limited effect on people’s decisions: it says that if a default is not aligned with people’s preferences, they will choose otherwise. The organ donation registration story reveals dramatically that this is not the case. Because of the power of inertia, people will typically do whatever the default is (See Figure 1.)
I hope you are as fascinated as I am by the way a basic psychological principle like inertia can literally save lives, when the default option is set correctly. But inertia applies to many other decisions, including saving for retirement, and that’s where the combination of psychology and finance, or behavioral finance, comes into play.
Kahneman and his long-time colleague Amos Tversky, a mathematical psychologist, did much of the important work that underpins behavioral economics, including developing prospect theory, which aims to explain irrational human economic choices. Nobel Prizes are rarely awarded posthumously. Kahneman, who received his Nobel Prize in Economics six years after the death of Tversky, told
The New York Times (November 2002): “I feel it is a joint prize. We were twinned for more than a decade.”
The default setting of many of the 401(k) plans in the United States is set up similarly to the German organ donation system; namely, they are opt-in. In this default environment, employees have to take action and sign up for the retirement plan in order to be savers. If they take no action, they are assumed to be eternal spenders who have no interest in saving for their future. Similarly, as noted above, some British employees are victims of inertia and fail to take action, forgoing a free retirement plan fully paid for by their employer.
Inertia, and other key psychological principles like cognitive laziness explain many of our money mistakes. One study, for example, found that millions of Americans could dramatically cut their mortgage payments if they were to take action and refinance their homes. However, many fail to do so (Campbell, 2006). Several factors contribute to this mistake of inaction, say the authors of the study, including the complexity of the decision and inertia.
Understanding the money mistakes people make is obviously a step in the right direction. However, behavioral economists ought to do more. I feel we should help people to make better financial decisions, and that’s where Behavioral Finance 2.0 comes into play.
WHAT IS BEHAVIORAL FINANCE 2.0?
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Behavioral Finance 2.0 goes beyond understanding the psychology of money mistakes people make: it is about designing behavioral solutions to avoid those mistakes. It does this by transforming behavioral challenges into behavioral opportunities. Its goal is to improve outcomes.
We have seen that inertia is often a behavioral challenge or an obstacle that prevents employees from saving for their future. While inertia is generally thought of as a behavioral challenge, Behavioral Finance 2.0 is about turning inertia into a behavioral opportunity.
For instance, one could make good use of inertia by changing the default so that employees are automatically enrolled in the retirement saving plan, unless they actively opt-out. With automatic enrollment, taking no action results in saving for retirement, which is what the majority of people say they want. Inertia is now an ally – not an enemy.
This seemingly minor change dramatically affects plan participation. The first study of this issue found that plan participation of new employees jumped immediately to close to 90%, compared with 64% for employees who had been on the plan for between three and five years (Madrian and Shea, 2001). By now more than a dozen such studies have been reported, and all show a similar boost. Automatic enrollment not only works, it is also extremely powerful.
The Pension Protection Act of 2006 encouraged plan sponsors to adopt automatic enrollment, and its popularity is growing. In 2010, 34.4% of plans had automatic enrollment for new hires and a further 7.4% offered it to existing, non-participating employees (PSCA, 2011). (Participation varies according to plan size; it is highest in large plans.)
Automatic enrollment is by far the most effective tool identified to date to increase plan participation. However, its strength is also a potential weakness, compounded by other psychological factors. Progressive plan sponsors who adopted automatic enrollment early on typically set the savings rate at 3%. Some feared a higher rate might provoke more participants to opt out. However, research shows that this is ungrounded (Beshears et al., 2009). A low initial deferral remains common today. In 2010, 61.8% of plans with automatic enrollment had an initial deferral rate of 3% (PSCA, 2011).
Of course, saving just 3% will not provide anyone with a comfortable retirement. The expectation was that plan participants would gradually raise their saving rate to a more adequate figure – 10 to 15%, for example. My colleague Richard Thaler and I predicted, however, that because of inertia most participants would stick with that initial low saving rate and fail to increase it. Indeed, an article in the 7 July 2011 issue of the
Wall Street Journal reported that 40% of new hires who were automatically enrolled in their company’s 401(k) plan are now saving less than if they had actively opted into their plans (Tergesen, 2011). We therefore designed a behavioral solution to help employees save more – tomorrow
The first ingredient of the Save More Tomorrow (SMarT) solution is to invite employees to save more: not now, but in the future. This feature assumes the same human tendency I will exhibit as I head out to the Toscana Restaurant with my wife, Lesli, as soon as I finish writing this article, praying that they still have plenty of my favorite profiteroles and naively believing that tomorrow, I will exercise more and eat healthily.
This self-delusion is based on the psychological principle of “present-bias,” where we heavily discount the future. So, tough tasks like dieting and saving seem easier to face – if we locate them in the future. Most people are master procrastinators, convincing ourselves that we will do the right thing tomorrow. Thaler and I therefore guessed that inviting plan participants to start saving more tomorrow, rather than today, would be perceived as more attractive. It was.
The second ingredient is to time the saving increases with pay raises, so employees save more when they make more money, ensuring that their take-home pay never goes down. This avoids loss aversion, which is hyper-sensitivity to losses or reductions in our spending. And the third ingredient is to put the program on auto-pilot, so employees automatically increase their saving rate every time they get a pay raise, up to a set target. On this auto-pilot program plan participants are spared the task of taking action and their saving rate climbs all by itself.
Deferral rates with and without save more tomorrow
In our first case study of SMarT in 1998, we faced a rather challenging environment: a company with rather low savings rates, especially among the lower-paid employees. The employer brought in a financial advisor and offered free consultation to all employees. Ten percent declined the invitation, preferring to make their own decisions. The average saving rate of this group was 6.6%. Almost a quarter followed the advisor’s advice to have a one-time boost in savings rate of five percentage points. The remainder, mostly the lower-paid blue-collar employees, said they could not afford to save more at that time. Their average saving rate was just 3.5%. We can call them “timid savers.” Yet, 78% of this group who could not save more at the time were happy to sign up to automatically save more in the future, every time they began to make more money. After three-and-a-half years and four pay raises, the average saving rate of timid savers had almost quadrupled to 13.6%.This was double the saving rate of employees who had elected to make their own saving decisions (Thaler and Benartzi, 2004; see Figure 2.) SMarT had empowered timid savers to become bold savers by transforming behavioral challenges into behavioral solutions.
As of 2010, more than half of the large employers in the United States have incorporated automatic saving increases in their 401(k) plans, and similar programs are being implemented in the United Kingdom, New Zealand and Australia. The SMarT program turned the behavioral challenges of present-bias, limited self-control, loss aversion and inertia into a behavioral solution that is likely to have already helped millions of people boost their savings. The key lesson here is that Behavioral Finance 2.0 not only works, it is also extremely effective at improving outcomes (Benartzi and Lewin, 2012).
While Behavioral Finance 2.0 has helped millions boost their retirement savings, there are many more opportunities to help people make better financial decisions. I am passionate about extending behavioral finance to the “decumulation phase” of retirement planning; that is, how people manage their finances after they retire. How do they manage the risk of outliving their money? Stay tuned as the Allianz Center for Behavioral Finance applies behavioral finance lessons to the monetary challenges that retirees face.