Whether you like it or not, you’ve probably already experienced a “nudge” today. Perhaps you slowed down as you exited the highway because you noticed the lower speed signs posted somewhere along the off-ramp. Or maybe you entered your favourite coffee shop intending only to buy your regular latte, but couldn’t resist getting one of the tasty baked goods conveniently (and enticingly) placed by the cashier.
Nudges – both subtle and overt – are everywhere and can be used strategically to guide people in their decision-making process, including when it comes to saving and investing. In their profoundly influential book, Nudge (first published in 2008, with a revised edition released in 2021), American legal scholar Cass Sunstein, and economist Richard Thaler outline how nudges can help people overcome biases and instinctive behaviours that result in less-than-ideal choices.
As one of the foundational books in the field of behavioural economics, the impact of Nudge can be seen everywhere, from presumed consent organ donation laws in countries like Spain and England, to retirement savings programs in the United States. But how can people apply these insights to investing? The first step is understanding them. Here are three key terms Sunstein and Thaler discuss in Nudge.
Choice architecture
At the heart of nudge theory lies one important principle: “If you want to encourage some action or activity, Make It Easy (p.106).” Simply put, how choices are presented to us is just as important as the choices themselves. For instance, a business that wants to save on energy bills and reduce carbon emissions may set the office thermostat’s default temperature a half degree cooler in the winter and warmer in the summer. That small change is unlikely to motivate employees to change the thermostat back to its original temperature.
Mental accounting
If you’ve ever earmarked a certain amount of money, say $80, to spend on food and games at an amusement park with your family, you’ve taken part in mental accounting. It’s a way for people to create parameters around spending in scenarios where they may lack self-control. Money, Thaler and Sunstein explain, is fungible – meaning it doesn’t inherently come with labels attached and can therefore be used to purchase quite literally anything. So, when you tell your children they only have 12 dollars left to spend on treats, the reality is that you have plenty more money in the bank that you could spend if you wanted, but you mentally labelled just 80 dollars as “for the amusement park.”
Status quo bias
Like the example of the default office thermostat setting, certain scenarios take advantage of a particular phenomenon – most people stick with what they know or what they currently have because it takes too much mental energy to do something different. Sunstein and Thaler point to the tendency of students to gravitate toward the same seats each week, even when there’s no assigned seating. However, status quo bias, or inertia, as it’s sometimes referred to, is often exploited by companies, such as offering a free trial subscription that automatically switches to a paid one, unless you go to their website and opt out before the trial ends. After all, isn’t it easier to let that subscription continue rather than jump through hoops to cancel before getting charged?
All these issues impact investors. For instance, if too many product options are presented, people might not invest in anything. If they don’t have a number in mind on when to sell, they could end up hanging on to a poor-performing stock for too long (which ties into loss-aversion bias, where people feel a loss more than a gain).
What can investors do?
Fortunately, there are strategies you can implement to overcome any biases that might hold your investment portfolio back, such as the concept of defaults. Many people have already set up automatic withdrawals from their bank accounts into their RRSPs. Still, Thaler and fellow behavioural economist Shlomo Bernartzi took this a step further when they designed the Save More Tomorrow program – a “nudge” designed to get American companies to enroll their employees into a retirement savings plan by default. The program, which automatically increases an employee’s savings plan deposits from payroll whenever they are given a raise, has been so successful that it was written into law in 2006 when it became part of the Pension Protection Act in the United States.
Canada doesn’t have the same rule, but many companies offer pension plans where you can automatically put money from a paycheque into an investment account. You can also do that on your own by automatically moving money from your chequing account every pay period into your Registered Retirement Savings Plan (RRSP). By baking increases into those automatic withdrawals over time, will lead you to save even more.
Similarly, status quo bias can prevent you from choosing better portfolio options as they become available. Proactively avoid this trap by doing your research – look at what investment options are out there, read up on different products and schedule regular check-ins with your financial advisor to ensure you’re getting the most out of your money.
When it comes to preventing losses, it may not be enough to just think about selling at a specific price, especially given how quickly the market can move. Instead, once you determine at which price you want to sell, set a stop loss order, where you’ll automatically sell when the stock you’re holding hits a certain price.
While many nudges are external – from the government in our best interests or from corporations looking to make money – investors can benefit most from personal or self-nudges. Setting up investment guardrails, reminders to check in with your advisor, or even just regular deposits into an investment account can help you maximize your money. And that’s something Sunstein and Thaler would be happy about.
