Imagine that you are the manager of a school cafeteria. The school offers a wide range of food and beverages. Suppose research shows that no matter what is at the top of the list, the top three items get ordered more than the rest on the menu. If the manager writes out “grilled chicken whole grain sandwiches” at No. 1 “cheese hamburger with fries” at No. 10, more kids will choose the healthier option.
Now, would you, as the manager of the cafeteria and a responsible parent yourself, leave the choice of the first three items to a random selection or take a conscious decision to put the three healthiest options first and then fill the rest of the menu with all others also on the list?
Without taking away the freedom of choice of the kids, they are being gently nudged into making better choices.
Also called manipulation of choice environment, this sort of research and ideas are coming out of work in one of the most fascinating branches of economics called behavioural finance (BF). This specific example is from a book written by behavioural economist Richard H. Thaler and law professor Cass R. SunsteinNudge: Improving Decisions about Health, Wealth and Happiness.
BF, the study of how psychology affects financial decision making and financial markets, began as a reaction against a world hypnotized by math fundamentalists who were basing all economic theory on a perfect world of rational economic agents and choices. Hello, said the BF pioneers, the world is not perfect and perhaps individuals are the least rational when it comes to money.
The academic world was not convinced and it took a Nobel Prize for Daniel Kahneman for his seminal work in establishing a cognitive basis for common human errors using heuristics and biases, before this area of economics got academic legitimacy.
Off the library shelves, we all experience tenants of BF in our daily lives. OK, what do you do with your leftovers each night —chuck them out immediately after the meal or stick them in the fridge? What do you do with a new pair of shoes that are tight (seemed OK in the showroom, but began to bite at first wear)?
Most people tend to act in a human manner (read illogical, irrational)—they stick the food at the back of the fridge and put the shoes at the far corner of the shoe rack. We hate to lose and do not like the feeling of coming face to face with the loss. That’s the reason we hold on to dud shares or funds or even insurance policies.
If loss aversion is human, so is the preference of current over delayed gratification. What would you prefer in a year’s time: one hour yoga class or one hour extra sleep in the morning? What if you needed to choose for tomorrow morning?
Research by D. Read and B. van Leeuwen (1998) shows overwhelming evidence that we like immediate gratification, but do still have noble intentions about our health and money. So 74% of the people prefer yoga after a year, but 70% would rather sleep in tomorrow morning.
The same rules work for investing. We’d like to begin a financial plan but will do so “later”.
The synthesis of years of work has now moved economics off the academic ivory tower and into the market place with the Richard H. Thaler and Shlomo Benartzi’s Save More Tomorrow (SMT) plan. The plan is based on the fact that we like current gratification but do have noble intentions and that we react to the choice architecture in getting nudged into making the “right” choices.
The SMT plan makes enrolment automatic in pension plans at a low initial rate, say 3% of basic income. But gets you to sign on hiking this to 5% in a year and higher in subsequent years. The success of this scheme has nudged financial firms such as Fidelity Investments, T Rowe Price and the Vanguard Group Inc. to introduce these schemes for their employees and commercially. The UK-based AXA Group has, as recently as October, offered it as a company pension plan in the UK.
Though such schemes are yet to come to India, a sort of a default option has always existed in the form of the Employees Provident Fund. You don’t have to opt in, participation is mandatory. But after the first Rs6,500 of basic salary, it is not. Yet, most employees still let employers deduct 12% of basic salary since nobody asks them to opt out.
Another way of saving by default for a large swathe of urban mass affluent has been to use the insurance premium and, more recently, the home loan EMI to automatically build reserves and assets.
The New Pension System, or NPS, makes a more sophisticated use of the default option. Unless the subscriber chooses the asset allocation of his retirement fund, NPS will automatically put him in an allocation based on his age. The default will also change the asset allocation in favour of safer debt as the person ages.
And the fly in the header? Thaler and Sunstein tell this story about nudging people into doing the right thing: “A wonderful example of this...comes from...the men’s rooms at Schiphol Airport at Amsterdam. There the authorities have etched the image of a black housefly into each urinal... They found that etchings reduce spillage by 80%.”
Nobody can resist taking aim, it seems. And some nudges work.
Monika Halan is a certified financial planner and policy analyst in the area of financial literacy and intermediation. Your comments and personal finance queries are welcome at firstname.lastname@example.org