Irrational profitability

Asa Fitch

• Last Updated: November 26. 2009 1:46PM UAE / November 26. 2009 9:46AM GMT

Richard Thaler, a professor of economics at the University of Chicago and author of the best-seller Nudge, told a Dubai audience that a few simple changes in thought and behaviour can work wonders for your portfolio. Nicole Hill / The National

Take a minute to answer this question: if you were offered Dh100 today or Dh110 in a week, which would you choose?

For most of us, the answer will be the Dh100 today; who wants to wait a week, after all, for a measly Dh10?

Now ask yourself the same question but move it up in time: If you were offered Dh100 in a year or Dh110 in a year and a week, which would you take? Recent research in the burgeoning field of behavioural economics suggests that most people will take the latter alternative.

In pure mathematical terms, that difference is a weird quirk. More money is presumably better, so it would stand to reason that people should always pick the Dh110. But they don’t. People, it turns out, aren’t quite as rational as the models that economists have based their theories upon for decades predict.

“If an economist gets an idea for how an economic agent might be even smarter, then that immediately becomes part of his theory about how everybody behaves,” Richard Thaler, a University of Chicago professor who is one of the leading lights of behavioural economics, said last week in Dubai. “So in economic theory, economic agents are always as smart as the smartest economist.”

That’s an assumption that behavioural economics attempts to blow to bits: that we’re all perfectly rational people who make perfect decisions based on perfect information.

The reality, of course, is a lot more complex, and proponents of this new branch of the dismal science argue that their assumption of flawed and very human economic actors leads to better, more nuanced conclusions.

Only by acknowledging our natural imperfections can we become more perfect, they say.

“We’re all human, and that means we’re imperfect,” Mr Thaler says. “We could all use a little help.”

How behavioural economists propose to provide that help depends on context.

Behavioural methods developed by the likes of Mr Thaler and Daniel Kahneman, who is considered the field’s founder and won a Nobel Prize in 2002 for his work in it, have been applied to everything from solving poverty to reducing energy consumption. The methods bend to fit the problems.

Yet there are some unifying principles. In Nudge: Improving Decisions about Health, Wealth and Happiness, Mr Thaler and Cass Sunstein, a former colleague of his at the University of Chicago, propose “choice architecture” as the basic framework through which behavioural economics can gently push people into decisions that make them wealthier and happier.

The idea behind choice architecture is that people’s decisions are influenced profoundly by how their options are presented to them. Mr Thaler illustrates the point by citing studies showing that the order in which food is presented in a school’s cafeteria has a major impact on what people eat. Items at the beginning and end of the line are more likely to be selected, as are those that appear at eye level.

Armed with that knowledge, a cafeteria’s manager can design its layout to make students healthier or unhealthier. But it’s impossible not to make a choice, Mr Thaler says.

“She has to arrange the food somehow,” he says. “Well, she could arrange the food to make the kids healthier or fatter. Or she could fool herself into thinking she was avoiding choice architecture by arranging the food at random or in alphabetical order. But that would just make it impossible to find anything.”

Shaping choice architecture around nudging people towards better financial decisions has been another big area of exploration for behavioural economists. And in financial matters, methods that exploit the human tendency to do nothing have been shown to work well. The research says people tend not to alter default settings on everything from mobile phones to pension plans – out of laziness, perhaps, or simply being busy. Defining those defaults can thus hugely influence behaviour.

In the US, for example, workers can enrol in employer-sponsored 401(k)s, pension plans named after the tax code that governs them. Employees can put in a portion of their gross salaries before taxes are deducted, and employers typically add a “match” that amounts to a percentage of whatever the worker puts in. Because contributions are exempt from taxation, they effectively amount to free money from the government.
And yet many workers don’t contribute to 401(k)s. At most workplaces, enrolment is on an “opt-in” basis, meaning an employee has to fill out a set of forms before he can start salting away money in his retirement portfolio. The default option, in other words, is to do nothing.

Recognising the power of the default, behavioural economists lobbied for years to get companies and regulators in the US to switch to an “opt-out” system in which workers automatically enrol unless they actively choose not to. Changing that choice architecture at a handful of large American firms has already resulted in many more people signing up and saving.

“Under the usual regime, when you’re first eligible to join the plan you get a pile of forms to fill out, and if you don’t fill them out you don’t enrol,” Mr Thaler says. “Under the new regime, you get that same pile, but the first page says if you don’t fill out these forms we’re going to enrol you anyway at this saving level and in this investment plan. Well, that simple change shoots enrolment up to almost 100 per cent.”

Default options, though, are just one of a number of behavioural factors that shape financial choices. Another one is the tendency to put off prudent financial moves for later. Just as most people will take Dh100 today instead of Dh110 in a week, most of us would rather wait to start on a savings plan or resolve to set aside more money for retirement.

We’re psychologically tuned to avoid pain and seek pleasure in the present, but we’re far more reflective – and generally better at making decisions – when those decisions only have negative consequences in the future.

To combat this, Mr Thaler and Mr Sunstein in Nudge propose the Save More Tomorrow plan. Under it, you commit to an automatic increase in contributions to a savings and investment plan, but only when you next get a raise. That forces you to think long term about savings and avoids the inclination to spend away when you start making more money.

“We all have more self-control for the future than for the present,” Mr Thaler says. “So many of us are planning a diet, but not tonight at midnight. And in fact, not before January 1. Many people are going to start diets on New Year’s Day. So what we do with Save More Tomorrow is we invite people to commit to saving more when they next get a raise – in a few months. The first company where we did this we tripled savings, and it’s now available at most large companies in the US.”

Giving feedback is yet another technique that behavioural economists have found effective in influencing financial decision-making. If people are reminded via a text message that they need to save more, for example, or if they are updated regularly on their savings progress in periodic e-mails, they’re more likely to take saving seriously.

Transparency has also emerged as a priority for behavioural economists who want to nudge us to save more based on our tendency to compare ourselves to our peers. If you know how your savings stack up compared with people of your age group and income bracket, the reasoning goes, you might change your lazy ways.

More transparency from financial institutions is necessary to put schemes like that in place, but similar experiments have already shown the promise of keeping-up-with-the-Joneses-style of nudging.

One effective way, for example, of reducing energy use – and saving money – is simply to print neighbours’ energy consumption records on utility bills. In Chicago, this simple measure has helped reduce energy use by about six per cent.

While behavioural economists have come up with many clever ways like these to improve people’s lives, the young field hasn’t been without its detractors. Its methods implicitly require practitioners to define good and bad outcomes. And though it doesn’t constrain freedom of choice, it does subtly guide people towards whatever choices those in charge deem desirable. That strikes some critics as overly prescriptive and even slightly paternalistic. Behavioural economists may not be making orders, but they do have a few suggestions.

Mr Thaler counters by saying that there are a lot of things we can all agree are good, and that all of the techniques he proposes still allow people to follow paths that diverge from the ones he envisions. He points to a system that sends text messages to remind people with diabetes to take insulin as an example of something few would contend excessively constrained choice. Thousands of people across the globe go blind and have limbs amputated because of failure to take diabetes medication even when it is readily available.

“People start worrying, oh, Thaler and Sunstein think they know what’s best for people,” he says. “It’s not that hard to figure out that most people would like to keep both feet. I’m not here to tell you whether you should like chocolate better than vanilla, but I’m pretty sure you want to keep both of your feet, and I’m pretty sure you want to have some money when you retire. So we can start with the basic stuff without getting too intrusive.”

None of these methods of guiding people to better financial, environmental or health decisions has yet been put into place in the Gulf. That is partly due to the fact that there are few financial structures in place, such as government-sponsored retirement investment plans or tax systems, that regulators could alter in an effort to get people to make better choices.

Still, Mr Thaler says the lack of such formalities shouldn’t discourage people and companies in the UAE from innovating and trying some of them out.

“I would say this is a huge market opportunity for somebody, because on their own people won’t save for retirement,” he said. “The rich are fine, but the everyday guy is not going to save for retirement.”

afitch@thenational.ae