You likely don’t realise it… but throughout your daily life, your behaviour is constantly influenced and manipulated, in ways that are sometimes beneficial to you – but also, sometimes not so much.
Think about a cafeteria… a more health-conscious one, for example.
You walk in and see prominently displayed juicy fruit cups and leafy salads. At the register, glistening bowls of shiny red apples and bright bananas beckon you. Meanwhile, the junk food – saggy, sorry-looking bags of potato chips and pretzels – is wedged at the back.
What kind of food are you more likely to choose?
It’s hardly surprising that in this case it’s scientifically proven that you’re more likely to go for the healthy options, simply because they’re more easily available and convenient. Yes, you still have a choice – but the way you decide has been manipulated.
In their book Nudge: Improving Decisions About Health, Wealth and Happiness, Richard Thaler and Cass Sunstein called this the “nudge effect”. In short, irrational flaws and biases pervade our thinking and our actions.
But a simple, and often very subtle nudge can encourage us to make much better decisions, whether it’s for the healthy lunchtime option… or, in another arena, regarding our economic and financial future.
The retirement fund nudge
The equivalent in the finance world is encouraging people to put money in their retirement funds.
Most people aren’t saving enough for retirement. A study in the U.S. by the National Institute on Retirement Security found that for working-age households the median retirement account balance is US$3,000.
And for near-retirement households, it’s just US$12,000. The study estimates a national retirement savings deficit between US$6.8 and US$14 trillion.
At their current trajectory, a lot of U.S. households are destined for tough times in retirement.
But a simple change in pension policy can encourage far more people to put more money away for retirement. The simple nudge is to switch the pension policy from one where an employee opts-in to a company pension plan – to a scheme that enrolls him/her automatically, but with an ability to decide to not participate if preferred.
In other words, the default option is to invest in the pension plan – rather than making this a decision that requires action by the individual.
The freedom of choice still remains. But under the automatic enrollment scheme, far more people end up saving into pension plans.
The pension regulator in the UK has reported that participation in private pension schemes increased from 42 percent to 73 percent in the period from 2012 to 2016, after default enrollments were put in place. The opt-out rate (that is, people who made and acted upon the specific decision to not invest) was a modest 12 percent.
This is a monumentally significant increase that in the long run could vastly increase the degree of economic security for hundreds of thousands of households.
The “nudge” effect has had a big impact on pensions in the U.S. and Sweden as well.
So what’s going on here?
Many of our decisions, or non-decisions, are because of the “default effect”.
Have you ever been overwhelmed by the choices in a restaurant’s wine menu and just decide on the house wine? Or, when you buy the latest electronic gadget, do you just accept the factory default settings and not even bother changing even the ringtone?
That’s the default effect.
Most people are happy to stick with the standard options. Even when we have several choices, we go with the default choice because it’s easier and more comfortable. Governments and other authorities know this – and use it to nudge us in a certain direction.
That’s why when the pension regulator in the UK put default enrollments in place, participation in private pension schemes dramatically increased.
Even when there is no default, or standard, option given, we tend to use the past as our default setting. Most people like to stick with what they know and are anxious about making big changes or taking on new risks, even if the change would be good for us.
Make the default work for you
This default bias is the offspring of two other biases: status quo bias and loss aversion. Keeping things the same (status quo) is convenient, and the pain of losing is greater than the joy that comes from winning (loss aversion). Put these together, and our brains often tell us it’s just easier to keep things the same and avoid any potential loss that might come from changing things. That can be good, if you can make the default something positive… but bad if it’s not.
For investors, this default bias can stop us from making changes to our portfolio or strategy because it’s inconvenient or it makes us feel uncomfortable. Or, it can cause us to just accept what our banker tells us, or what they are trying to sell us, because it’s just easier to do. We tend to cling to the way things are, even if it’s not the best thing for us.
To deal with this, you need to change the default setting on your own thinking from time to time. Look at all the options and take the time to assess which one is best for you. Research what you don’t understand and make an informed decision. Then, change to create a new default.
It will pay off in the long run.
