Behavioral Finance

One of the most interesting areas of financial research these past ten years has come, oddly, not from economists or investment researchers, but psychologists, who are pioneering a branch of study known as "behavioral finance."  This has led to one of the strangest sights in the history of Nobel prizes: the 2002 prize in economics handed out to psychologist Daniel Kahneman for (according to the Nobelprize.org website) "having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty."

The behavioral finance research tells us that most people take mental shortcuts to arrive at decisions, and some of them lead to odd conclusions.  Around the time you make your New Year's resolution to lose weight, do you buy a $500 annual membership to a gym or opt for a $10 per visit pay-as-you-go fee?  Most people who choose the former end up actually going to the gym less than once a month; the flat fee is only a bargain when you assume that the bold post-resolution intention will actually happen, but it's often a terrible deal when a person's actual behavior is taken into account. 

How do you decide whether to be an organ donor when you face the option on your driver's license application?  In countries where the default option is yes (you consent to be an organ donor), 90% of individuals happen to be registered organ donors.  In countries where the default option is no, the percentage ranges from 10% to 30%.

This research is now finding its way into the hands of policy makers, who are pioneering a new governmental role of protecting you against the dangers of your own mental shortcuts.  One recent example is automatic enrollment in a company retirement plan.  Research shows that if people are required to affirmatively opt-into having a portion of their paycheck sent to their 401(k) retirement plan, they will do so at a lower rate (67%) than if they are enrolled by default and have to affirmatively opt-out (77%).  The U.S. government has been encouraging auto-enrollment policies at American corporations, on the theory that workers will be better off if more of them are making regular 401(k) plan contributions.

Another example in Britain came when the government offered tax incentives for people to insulate their attics, reducing energy consumption and the associated pollution from energy production.  But so few people showed an interest in the incentives that the UK government finally had to switch tactics.  It offered the same tax break, but added a loft clearance service that would help people clean out their attic and give them assistance in disposing of (sell or throw away) unwanted items.  The new service tripled insulation participation rates. 

When the city of Copenhagen painted green footprints on the sidewalks leading to  litter bins, littering decreased by 46%.

The idea of applying behavioral economics to political and social initiatives sounds a lot like manipulation to its critics, who worry that we are moving toward a "nanny state" where the government feels compelled to protect us from our own behavioral biases.  Reducing litter on the streets of Copenhagen is relatively noncontroversial, but what about initiatives that try to influence buyers to select more energy-efficient cars?  Or government policies that discourage the consumption of certain foods or beverages?  The New York City ordinance against large soda containers was based on the assumption that people were unable to recognize, on their own, the health risks of soda consumption.

Interestingly, at least one of these behavioral initiatives is now showing evidence of backfiring.  The Center for Retirement Research at Boston College found that companies that have switched to automatic enrollment in their 401(k) plans have been paying for the additional cost by giving their employees smaller employer matches--3.2%, compared with an average 3.5% for plans without automatic enrollment.  At the same time, the Boston College researchers and the Vanguard organization have found that for some workers, the automatic savings rate offered in the default is lower than what many workers would have chosen if they had made an affirmative decision to participate.  Worse, the automated mix of investments (typically target date funds) that is the default option has underperformed the investment mixes that workers have tended to select on their own.  For some workers, at least, the government's behavioral finance nudge will cost them real money.