Nudges are still the best way to tackle investor inertia

Human beings are inherently bad at making sacrifices today for the long-term welfare of themselves and their offspring. We see that in our seeming inability to deal effectively with climate change or save sufficiently for retirement. Perhaps the best response is a form of “libertarian paternalism” that “nudges” us to good decisions. In the latest in our series on the best books on finance and investing, we feature a recently updated version of a best-selling book by Richard Thaler and Cass Sunstein that explains why gentle nudges are so effective.

This concept of improving choice architecture in a way that helps people make better decisions for themselves and their families was first expressed in the 2008 best-selling book Nudge: Improving Decisions About Health, Wealth and Happiness by American behavioural economist Richard Thaler and legal scholar Cass Sunstein.

Thaler and Sunstein proposed a series of reforms for policymakers to help lead people to make better choices without restricting their freedom to choose. We need these ‘nudges’, they argued, because we have evolved to use mental short-cuts or behavioural biases to make big decisions. While sometimes useful, these short-cuts more often than not lead to poor judgement calls.

Why nudges are needed

For example, we are prone to “anchoring bias” when making decisions. This occurs when we rely too heavily on the first information that we receive. A classic case is when a car salesperson shows you a vehicle at a very high price, knowing full well that it is out of your range, and then proceeds to show you a discounted model. The second car may still be a complete rip-off but it looks like a bargain in comparison with the first.

In finance, people saving for retirement may be bedazzled by a plethora of fund options, many of which are inappropriate for their risk appetite or goals. A better approach may be to present them with a shorter list of default options that are low-cost, diversified and transparent index funds built around vanilla stocks and bonds.

The principle behind the nudge idea is that more choice on its own is not necessarily a good thing. Society benefits from people making good decisions about their retirement. So it is in our interest to encourage them away from choices that might offer tempting short-term rewards (think ‘high-conviction’ funds where the risks are hidden) and steer them toward evidence-based investment solutions that are highly diversified.

An everyday example of the nudge at work is in a school cafeteria. Instead of putting all the junk foods like crisps and chocolate at arm’s reach, the school may decide to put the healthier options front-and-centre. It’s not that the junk food is off the menu entirely. It’s just that it’s not so easily accessible.

The whole idea of the nudge is to make it easier for the consumer or citizen to make choices that are better for their long-term welfare. Fintech that encourages consumers to round up the purchase price of their chosen item and put the extra into their retirement accounts is one example. An insurance default that covers most eventualities is another.

Updated edition

In the 13 years since Nudge was released the concept of libertarian paternalism has developed (the UK Government now even has a Nudge Unit) and the authors have learned a lot more since then about what has and hasn’t worked. Meanwhile, Thaler himself has since been awarded the Nobel Prize in economics.

In a recently updated version of the book, called Nudge: The Final Edition, Thaler and Sunstein introduce some new concepts. These include a chapter called “Sludge”, which is about the tendency of governments, agencies and businesses to insist on cumbersome and time consuming form-filling that works against good decisions.

In response to this, the authors propose organisations come up with pre-completed forms that can be filed with one or two clicks, as well as cutting back the forms required to get licences, visas, permits, financial aid and health insurance.

Other new suggestions are improved choice architecture concepts such as personalised defaults, particularly in relation to financial decision-making. The book also explores how governments and health services have nudged people into taking sensible precautions against coronavirus, and how nudges might help to combat to climate change.

The right tools for the job

Ultimately, the nudge concept is not about taking choice away from people but giving them the tools to make better decisions for their long-term welfare.

“It’s like giving someone an alarm clock,” Professor Thaler told Prospect magazine in a recent interview. “That helps them get up in the morning. But they still set the time that it goes off and they have the ability to either hit the snooze button or turn it off.”

Ultimately, the case for gentle nudges is based on a recognition of how human beings really behave, not on how the economics text books so they should behave. As Thaler says, we should never under-estimate the power of inertia. The good news is that power can be harnessed for the long-term welfare of individuals and society generally.