Nudging Yourself to Better Investment Decisions
It’s been more than 10 years since the publication of Nudge, by Richard Thaler and Cass Sunstein ― and in that time, it’s been enormously influential. In the world of public policy, for example, it led to the development of “Nudge Units” within many governments, perhaps most notably the Behavioural Insights Team (BIT) in the U.K., which was set up to apply nudge insights to improve government policy and services. Nudge has also gone a long way in popularizing the field of behavioral science by paving the way for broader awareness of other important thinkers and their ideas.
While Nudge has had a tremendous impact on a global level, its insights are also very applicable on a personal level. We may not realize it, but we’re being “nudged” all the time – while we’re shopping, working and investing. That’s why we think it’s worthwhile to take a step back, highlight some of the “big ideas” from Nudge – and consider how we can use the principles to improve our own lives and decisions.
WHAT’S A NUDGE?
“A ‘nudge’ is a small aid that leads people to adopt a desired behavior.” The underlying idea is that small cues or changes in our environment can have a major impact on our choices and behavior. For example, when several cafeterias put fruit, instead of candy bars, next to the cash register, people were “nudged” to eat over 25% more fruit – simply because they are more visible.1 The premise is that purposely designing our lives (our environments, our habits and our processes) in this way will ultimately lead us to better decisions and outcomes.
Much of Thaler’s focus has been on applying “nudge” principles to encourage and promote retirement savings. He partnered with Shlomo Benartzi, a Professor at UCLA, to create the “Save More Tomorrow” program, which has led to significant increases in retirement savings.2 In fact, the application of Thaler’s work is credited with adding nearly $30 billion to retirement accounts.3
THE THREE CORE IDEAS THAT DISTINGUISH NUDGES
1. Nudges never force people to make certain decisions.
A core principle is that, while “nudges” may lead people in a certain direction, they never limit or eliminate options. The ultimate choice still lies with the person – and in this way, a “nudge” is different from a rule or a law. The authors assert that “a nudge is any aspect of choice architecture that alters people’s behavior in a predictable way without forbidding any options or significantly changing their economic incentives.” Putting fruit at eye level, as they did in the cafeteria example, counts as a “nudge.” Banning candy bars doesn’t.
2. Nudges leverage behavioral science insights about how we make decisions.
“Nudges” are effective because they draw on heuristics, or mental shortcuts, and cognitive and emotional biases that impact our behavior. For example, “Save More Tomorrow” has worked because it asked people to make a savings commitment in the future – when they got future pay raises. This taps into “present bias," which is our tendency to overvalue immediate rewards at the expense of long-term goals. When it comes to financial decisions, present bias can have a devastating effect. Overspending today can drastically reduce saving for the future. Take retirement, for example. At the start of your career, saving money for retirement may take second stage to fun vacations and extravagant purchases. But, the longer you wait to start saving, the harder it will be to meet your goals. Eventually, that lack of long-term planning and saving can have a significant impact on your retirement readiness.
3. Nudges are meant to be used for good.
Certainly, “nudges” can be applied for good or bad: People can be “nudged” into buying more products, booking more expensive hotel rooms and making less than optimal investment decisions. However, Thaler and Sunstein have always emphasized the idea of “nudging” people as a means of helping them accomplish their desired goals, be it saving, eating healthier, sustainability, charitable giving, etc. In other words, “nudges” are meant to help us move from “intent to action,” rather than convincing or persuading us to do something that we had no intention of doing.
HOW DO NUDGES ACTUALLY WORK?
There is a wide variety of different interventions that can be classified as “nudges.” But the common theme is that they involve typically small changes in our “choice architecture” – the way we encounter options in our physical environments – in order to make it easier for us to make the “right choice.”
In fact, many of the most effective “nudges” involve the use of “defaults” that lead people to the desired action or activity, unless they take conscious action otherwise. In Nudge, the authors provide this example: When people in the U.S. have to “opt-in” to become organ donors, only about 42% chose to do so. But when they are automatically enrolled (unless they object), 82% agreed to become donors.
This “automatic enrollment” approach has also been used successfully in helping people save more in their retirement plans. And interestingly, behavioral scientists have found that limiting choices has been effective in driving enrollment. That’s because when we encounter too many options, it creates confusion and hesitation, and we’re less likely to take any action. This is known as the “the paradox of choice.”4
APPLYING NUDGES TO YOUR LIFE
One of the most remarkable aspects of Nudge is how broadly the concepts can be applied. On one level, they can be applied to our own lives, to improve our own decisions and actions by “nudging” ourselves. The authors assert that “you can make small changes in your own environment – or interventions in your processes – to help facilitate a range of personal goals, including financial well-being.” Think of these as adopting new habits. And, behavioral science has uncovered many successful strategies, to help us “nudge” ourselves into better habits, like “temptation bundling.” Coined by behavioral economist Katherine Milkman (professor at The Wharton School of the University of Pennsylvania), temptation bundling is a clever method of using rewards – or the things we enjoy doing – to invoke the willpower to do the things we don’t want to do, things that often come with long-term benefits.5 Exercising while watching your favorite TV show is one example – bundling something you may not want to do with something that gives you pleasure.
Importantly, the key ideas from Nudge can be applied to help us make better investment decisions. This can start by simply being aware of the biases that are common to investors and often lead them to make sub-optimal decisions. These include the loss aversion bias, which is our tendency to weigh or feel losses much more heavily than we do comparable gains and confirmation bias, which is our tendency to overvalue new information that aligns with our beliefs and discount. Another way of incorporating a “nudge” into an investment process is including a framework that prompts questions. For example, inserting a step each quarter that asks investors to reiterate their longer-term investment goals and objectives, as well as their short-term needs, can help keep them on track.
And finally, there is the opportunity to use the “nudge” techniques that have proven effective in helping investors reach their financial goals. Certainly, we’ve seen the power of defaults and precommitment systems in “nudging” people to save and invest – and they can also be applied to encourage charitable giving. At its heart, Nudge is about harnessing the power of behavioral science to help us move from “intent to action.” And certainly, this challenge, and opportunity, applies directly to investors, who can apply this power to help make better decisions – and drive improved outcomes – in their financial lives.
BEHAVIORAL SCIENCE IN ACTION
PIMCO has long understood that behavioral science can make us better investors. That’s why we’ve partnered with some of the best minds in the field at the Center for Decision Research at The University of Chicago Booth School of Business. Through this innovative partnership, PIMCO supports diverse and robust academic research that contributes to a deeper understanding of human behavior and decision-making. Learn more about how behavioral science can make you a better investor.
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