Behavioral Finance 1.0: Money mistakes

Behavioral finance combines psychology and financial economics, and examines what can lead people to make bad financial decisions.
The poor financial decisions we make now will haunt us in retirement and are often down to .../ Credits: Reuters
Behavioral finance is grounded in insights for which Daniel Kahneman, a psychologist, was awarded the 2002 Nobel Memorial Prize in Economics. Kahneman and his colleague, the late Amos Tversky, were fascinated by “mistakes” many people systematically make around judgments and decisions, because of fundamental psychological factors.

One of the most important sets of financial decisions people make in their lives is planning for their retirement. Whether an individual elects to enroll in a retirement plan, how much they decide to save, and how wisely they invest all determine whether their “golden years” are indeed golden.

The alarming reality is that most people make poor decisions around retirement planning and face a dramatic drop in their living standard when they stop working. Some of these poor decisions, which are important money mistakes, illustrate what behavioral finance is.

In the United States, about a third of workers with access to an employer-sponsored retirement saving plan, such as 401(k)s, fail to join the plan. By failing to save for retirement, millions of American workers forgo the tax benefits associated with 401(k) plans and (where it applies) the matching contributions offered by employers.

Evidence from the United Kingdom is even more puzzling as certain defined benefit plans don’t require employees to contribute anything at all. All employees have to do to benefit is to sign up.

Remarkably, half of the eligible workers fail to join a retirement program that is totally free to them and fully funded by the employer. It’s not that workers don’t want to join a retirement plan in most cases. Quite the opposite is true. Research shows that most want to join, and often say they intend to do so, “in the near future.”

One study found every single employee who attended a financial education seminar declared his or her intention to start saving for retirement, soon. Yet, only one in seven followed up on their good intentions within three months (Choi et al., 2006).

Given the dramatic disconnect between good intentions and actions to fulfil those intentions, I argue that millions of employees around the globe are making a money mistake by not saving for their future.

Let’s review how behavioral finance can explain why people often make such money mistakes – decisions that are against their best interests.

Three important psychological factors that lead people to make money mistakes are inertia, myopia (or “present bias,” as it is often referred to), and loss aversion, which refers to the observation that most people are hypersensitive to losses: we feel the pain of a loss of a given size much more than we feel the joy of a gain of the same size.

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The power of inertia

In the case of failure to enroll in a retirement plan, our interest is in inertia, a powerful psychological force that readers will recognize in their own lives. Inertia, also known as “status-quo bias”, is psychological resistance to change, and it affects a lot of our decisions (or lack thereof).

Inertia is related to the behavioral principle of cognitive laziness, or the desire to minimize thinking costs. Herbert A. Simon, the first psychologist to win the Nobel Prize in Economics, stressed the minimization of cognitive effort in decision making.

The powerful role of inertia can be seen in a literally lifesaving domain, that of organ donation. Twelve percent of Germans make their body organs available for donation upon death. Given that information, I would like you to estimate the percentage of neighboring Austrians who donate their organs.

Most people who do this exercise guess that somewhere between 10-20 percent of Austrians make their organs available for donation when they die. People tell me that they base their estimate on the fact that since Austrians are neighbors of Germany and are culturally similar, they are likely to have similar donation rates.

Well, believe it or not, 99.98 percent of Austrians make their organs available for donation upon death! Put differently, out of 10,000 Austrians 9,998 are donors and only two are not. By comparison, out of 10,000 Germans, 1,200 are donors and 8,800 are not.

What can explain such a dramatic difference in behaviour between neighboring nations? (Johnson and Goldstein, 2003.) Yes, you guessed it right: inertia. Organ donation in Germany is an opt-in, or explicit consent, system. People have to actively sign up to be a potential organ donor at death, and those who take no action are assumed non-donors. In other words, the default setting in Germany is non-donor.

In contrast, the Austrian system is an opt-out, or implicit consent, system, where everyone is assumed to be a donor, unless they opt-out. The default setting in Austria is to be a donor.

According to standard economic theory, defaults should have limited effect on people’s decisions: it says that if a default is not aligned with people’s preferences, they will choose otherwise. The organ donation registration story reveals dramatically that this is not the case. Because of the power of inertia, people will typically do whatever the default is.

I hope you are as fascinated as I am by the way a basic psychological principle like inertia can literally save lives, when the default option is set correctly. But inertia applies to many other decisions, including saving for retirement, and that’s where the combination of psychology and finance, or behavioral finance, comes into play.

The default setting of many of the 401(k) plans in the United States is set up similarly to the German organ donation system; namely, they are opt-in. In this default environment, employees have to take action and sign up for the retirement plan in order to be savers. If they take no action, they are assumed to be eternal spenders who have no interest in saving for their future.

Similarly, as noted above, some British employees are victims of inertia and fail to take action, forgoing a free retirement plan fully paid for by their employer.

Inertia, and other key psychological principles like cognitive laziness explain many of our money mistakes. Understanding the money mistakes people make is obviously a step in the right direction. However, behavioral economists ought to do more. I feel we should help people to make better financial decisions, and that’s where Behavioral Finance 2.0 comes into play.

This article was first published in Project M.

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