Whether you know it or not, you and your clients encounter decision architecture based on behavioral economics in almost every financial decision.
Businessweek recently ran an article in its Opening Remarks section titled "Nudge Not." The title is a play on Richard Thaler and Cass Sunstein's book Nudge and offers a perfect segue into our next few articles.
We are beginning to look into some amazing everyday applications of behavioral finance and economics. Some are obvious. Some are not. All are used to affect our decisions to buy, sell, borrow, and even cheat and steal.
We want to understand how the observations from behavioral economics are used against us so that we can make better decisions for ourselves and our clients. We say "against us" because whether the policymaker or marketer who is wielding these tools is doing so for positive or negative reasons, they are in fact trying to change the way we make financial decisions and, by extension, working against our natural human tendencies.
The "Nudge Not" article looks at the effect, positive or negative, of the Obama administration's use of behavioral economic theory in the Making Work Pay tax credit. We are not privy to the underlying thought process that went into creating the tax policy, but the author submits that the Obama Administration structured the tax credit as a payment over time, rather than a lump sum as previous economic stimulus payments have been. They did so in the hope that this would encourage Americans to spend the money, and this would result in a bolstering of our economic circumstances.
The structure of this tax credit was meant to take advantage of our human tendency to do mental accounting. Policymakers hoped that a small incremental increase in monthly take-home pay would be accounted as current income and spent, rather than accounted as current assets and saved. It turns out we do have this tendency to make financial decisions differently based on whether we account for money as part of income or part of assets. The structure of the Making Work Pay credit is simply a clever way to combat the paradox of thrift using observations from behavioral economics.
We tip our hats to the Obama Administration for trying their hand at a Nudge. The jury is out on whether it worked.
One of us recently saw Dan Ariely, author of Predictably Irrational and The Upside of Irrationality, speak at the annual convention of the International Academy of Collaborative Professionals. The room was full of divorce lawyers, mediators, mental health experts, financial advisors, and other professionals interested in resolving disputes outside of court through a model known as "collaborative practice." This is a growing avocation in the world of divorce and family law, and they were all very interested to hear Ariely's insights into how we make financial decisions. One of the main takeaways from Ariely's presentation was the value of default options or opt-out programs. Here is an example from American policymakers:
During the Bush Administration, concern over the health of the American Social Security retirement system and discussions about how to fix what ails the programs reached fervor. Policymakers asked how the average American might be encouraged to save for retirement on their own so they would not be forced to rely on the Social Security system alone. It turns out Americans aren't very good at saving for themselves, so Congress took matters into their own hands and created the Pension Protection Act. Among other things, the Pension Protection Act creates incentives for employers to build opt out provisions into 401(k) plans. Such plans automatically enroll employees into deferring a minimum amount of their pay into a 401(k) savings plan. They can only stop this automatic enrollment if they opt out of the plan. At the time of enactment, the Employee Benefit Research Institute projected that this change could double the number of American workers participating in 401(k) savings plans.