Nudging for Better Financial Decision Making

– Mayank Prakash Regional Director, Delhi NCR, Epsilon Money

Ms Moneypenny, a middle-aged professional, has been working in an engineering firm for a long time. She has been handsomely paid for some time now which she has been spending the money on beautiful designer bags that she prizes. After a recent party where her friends mentioned how well they are placed in terms of their retirement, she has been hit with this realisation that she has not planned her retirement at all. She wants to invest the right way. She has some investment ideas that she thinks would DEFINITELY work for her. She has been known to be stubborn in her profession but that has worked for her there. She thinks she has read enough articles and gone through enough past data to determine what she needs.

You are a financial advisor who has been there and seen it all, markets crashing and then zooming and then crashing again… Should you disregard her choice of financial planning and prescribe her a remedy designed by sophisticated financial minds? Or should you persuade her to believe that she might be better placed to believe the experts and not invest with her ideas. Perhaps we could “Nudge” her towards the right financial way!

Don’t Judge, Nudge!

Nobel Prize winner Behavioural Economist Richard Thaler defines Nudge as any aspect of the choice architecture that alters people’s behaviour in a predictable way without forbidding any options or significantly changing their economic incentives. Nudging is one of the most powerful tools in Behavioural Economics. It has been a recipient of widespread research in Economics with extensive applications in Economics and Finance. Nudges are effective as they draw on heuristics, or mental shortcuts, and cognitive and emotional biases that impact our behaviour. To count as a mere nudge, the intervention must be easy and cheap to avoid. Nudges are not mandates. Putting the fruit at eye level counts as a nudge. Banning junk food does not. Nudge has been used extensively in finance to inculcate financial planning, financial discipline, and overall make more informed financial decisions.

Well Designed Financial Planning

Financial Planning is paramount in the phase of wealth creation. Investment is a mechanism to trade off current consumption for future consumption. Investment guided correctly pays immense dividends in the future. It is a fact that not all of us are adept at financial planning and we need experts to guide us through the process. But every investor has all the right to structure her own investment her own way. The problem is that the investor may not be an expert at this so she might not choose the optimal asset allocation as may be the case with Ms Moneypenny. One way to Nudge investor to the optimal asset allocation is by keeping the default as expert recommended asset allocation. Behavioural Economics research has shown that people show willingness in choosing the default option than to choose an option where their mental faculties would be required to be used. A simple way to Nudge people in this situation would be to put a message when people choose not to go with expert recommended asset allocation. A small message could read “This is an expert designed portfolio. There has been extensive research driving this portfolio allocation. Please make your choice while keeping this in mind”. Notice that we did not limit or forbid any option for the investor. Rather we guided the investor to a better outcome. We Nudged them!

Well Behaved Financial Behaviour

Financial Discipline is the backbone in the process of investing. Behavioural Economic research has shown that most of us humans suffer from Present Bias especially in investing activities. Present Bias is an inclination to prefer present smaller reward than larger later rewards but reversing this preference when both rewards are equally delayed. For example, a payment of Rs 100 today may be preferred than a payment of Rs 106 in 2 weeks. But a payment Rs 106, 8 weeks from now might be preferred compared to Rs 100, 6 weeks from now. An investor might prefer to consume today than to invest. Overspending today can drastically reduce the spending for tomorrow. Ms Moneypenny’s expensive handbags are one classic example of that. Though they are beautiful, but they may lead to suboptimal saving for her retirement. At the start of your career, saving money for retirement may take second stage to fun vacations and lavish living as was the case with Ms Moneypenny. But, the longer she waits to start saving, the harder it will be to meet her goals. Nudge has huge application in enabling people to save more. “Save More Tomorrow” programme designed by Richard Thaler and Shlomo Benartzi to encourage retirement savings has worked because it asked people to make a savings commitment in the future – when they got future pay raises. This becomes a very potent tool to get people to invest in their future effectively. A similarly designed programme at the micro or enterprise level can have huge implications in retirement savings of the employees.

Let’s be Smart About it!

These small interventions can have huge implications in the long run informed financial decision making. Ms Moneypenny can really benefit from these small tweaks. All of us know a Moneypenny who doesn’t believe in savings and others like Mr. Bond at the other end of the spectrum who only invest in safe haven securities like bonds or even keep their money in the bank.

Both need a little Nudge in the right direction to ensure that once they hang up their guns, oops, boots – they have a nice retirement corpus that they can avail of. One that can withstand the turbulence that the markets and economic environments can throw.

As we know small changes can make big difference. It’s a cheery on top if the small changes do not cost much!