A nudge, as we will use the term, is any aspect of the choice architecture that alters people’s behavior in a predictable way without forbidding any options or significantly changing their economic incentives.
Richard Thaler and Cass Sunstein
Richard Thaler is a Nobel Prize Winner and American economist specialised in behavioural finance. He has collaborated with Daniel Kahnemann (Thinking, Fast and Slow), Amos Tversky, and other experts in this field. He is responsible for creating a novel field in the area of behavioural economics through his empirical findings which is rapidly gaining traction in academia. Thaler is also the founder of an asset management firm (Fuller & Thaller Asset Management). He featured in the investing classic The Big Short as himself, explaining the hot hand fallacy to Selena Gomez, in which market participants think that whatever is happening right now will likely continue to happen in the future.
Cass Sunstein is an American legal scholar and specialises in administrative and environmental law, and behavioural economics. He was the Administrator of the White House Office of Information and Regulatory Affairs in the Obama administration between 2009 to 2012. Sunstein was also a professional squash player, reaching 449th in the world rankings.
Thesis
This book on trading argues that people often make poor choices and look back on these with amazement. This is because as humans we are susceptible to a range of routine biases. These biases mean we may make choices in personal finance, education, healthcare, and more, that may not be in our own self-interest or future selves. Nudge shows how people can make changes to their everyday lives by changing the way we see decisions.
Contents
The book is split into four parts: humans and economy, money, society, and extensions and objections.
Humans and economy looks into biases and blunders, resisting temptation, following the herd, the factors of choice architecture, and when we need a ‘nudge’.
The money section looks at how we save money, naïve investing, credit markets, and social security.
Society is all about saving the planet, increasing organ donations, prescription drugs, and privatising marriage.
Part four looks at several nudges that provide tangible and real world results, objections to nudging, and the ‘real third way’. A postscript of the 2008 Financial Crisis is given.
Key Themes
The choice architect
The ‘choice architect’ is introduced in the beginning of the book. This is someone who has the influence to make changes to peoples’ lives, regardless of how big or small. There are many choice architects throughout life, ranging from politicians and presidents, all the way down to shopkeepers and dinner ladies.
An example is given of Carolyn, a director of food services for a large city school system. She has a Master’s degree in Nutrition, and having conversed with her friend who works as a strategy orientation consultant in supermarkets, decides to test if the location of food would influence pupils’ choices over what they eat. Carolyn finds that she is able to increase or decrease consumption of specific foods by as much as 25%!
However, Carolyn finds herself in a dilemma with this new revelation. Does she:
- Arrange the food to make the students best off nutritiously, though this is obviously subjective to her own opinion.
- Choose the food order at random, which would mean some children would have healthier diets than others, which as a director of food services would not be ideal.
- Try to arrange the food to get children to eat what they’d be most likely to choose. This would be incredibly difficult as how would anyone know what every child would be most likely to eat?
- Maximise the sales of the food items where the suppliers are willing to offer the largest bribes, which is obviously corrupt.
- Place the food in order to squeeze out the most profit possible. This would then be putting profit ahead of the health of the children.
If you would pick option 1, then you are in line with the thesis of the book: libertarian paternalism. The authors believe that everyone should be free to choose. They should be free to smoke cigarettes and consume junk food if they want to. The paternalism part refers to putting the health food at eye level, or moving cigarettes from the shelves and having to ask to buy them. These actions are referred to as ‘nudges’. One such nudge in Schiphol airport male toilets managed to reduce spillages by 80%, just by putting a picture of a fly into the urinals.
Naïve Investing
Humans are terrible at managing their own investments despite there being an abundance of economic and financial literature freely available distributed throughout the world and across the internet.
Humans are loss averse and we feel the pain of losses roughly around twice the power as much as we feel the joy of gains. The eighty-year period fro 1925-2005 yielded a 3.7% rate of return per year for every dollar invested in a US Treasury Bill (T-Bill). However, a dollar invested in the largest American companies would have grown 10.4%. Peter Lynch has shown in his book X that stocks are always a better buy than bonds, aside from when X. Yet many still devote significant parts of their portfolio to bonds, despite the overwhelming evidence suggesting this should be heavily weighted (if not all) in to stocks!
Data acquired from Vanguard shows that many people were buying stocks consistently when equity prices were high, and most selling came from when stocks were low. This sounds obvious, as there has to be more net sells than buys to push prices lower, but this is consistent that many private individuals were selling their equity funds into the 2008 Financial Crisis, which was the time to be buying. As Warren Buffet says: “Be greedy when others are fearful”.
Humans intuitively diversify, and whilst this is no bad thing, it can be harmful to one’s future. Another damaging factor can be that humans are often very present. A recent study showed 2 out of 3 millennials in the US had no savings for retirement. Whilst they have plenty of time to do this, it has been shown that it is time in the market where large growth in stocks comes from. In the US, many employees offer to match an employee’s contribution to a pension plan by 50%. As contributions are tax deductible this match is free money, and yet enrolment rates in such plans are around 30% at the time Nudge was published.
This is similar to the LISA in the UK – the government will grant 25% extra of the account tax free with a contribution of up to £4,000 – which means £1,000 of free money, but this is not utilised by many. There is the disadvantage that it can only be withdrawn at a much later date or for a first house purchase, but this is free money that the government give away and yet nobody is interested. The book argues the case that by nudging people into these enrolment plans, they would then have to opt out, and this would not be very likely.
Incentives and motivation
Loss aversion can be used to motivate and nudge people to their best interests. The example is given of a colleague David (name switched to protect anonymity) who was offered a job with the expectation that he would complete his Ph.D. before he arrived at the faculty. Despite the financial incentives to do so, David always procrastinated. This changed when the Thaler offered David a deal; David would write a series of checks for $100 to be cashed in by Thaler if David did not submit a copy of a new chapter of his thesis. This works because the pain of losing a small amount, against the missing out of much larger amounts, is a powerful motivation factor.
Another example is given of a festival where organisers are concerned about hydration. They realised that by changing the signage from “drink more water” to “you sweat in heat: you lose water” they were able to play on peoples’ loss aversion and so dehydration cases lessened.
Nudges in everyday life
We are the recipients of nudges every day, for example in the supermarket when we can buy two and get one free though we only wanted one. Loss aversion and paying a higher price per unit tempts us into parting with more of our cash. These can be good deals for an item that is regularly used such as toothpaste, but buying three cookies when we only wanted one? Not such a good deal.
Products are placed at the most attractive level and in sections where they complement each other. The smell of baked bread is wafted around the supermarket to encourage people to buy more. The list is endless. Being aware of these nudges, both good and bad, will only help you to make smarter decisions in your own personal and business lives.
Conclusion
The authors believe in preserving freedom of choice. This is important because once we actively stop people from enacting upon their wishes we make the move towards a totalitarian state. Their goal is to ultimately help people make better decisions and choices without removing the right of choice. We often succumb to short term temptation at the detriment of our future selves; sacrificing the fruits of tomorrow for the rewards of today.
The book has real world application as can be seen with the opt-out schemes that retain 90-95% of employees, which benefits their financial lives. Opt-in has much less participation rates and even simple nudges can have huge cumulative effects. Choice architects have the power to influence the masses (not always for the best) and this book is a worthy read for anyone interested in behavioral economics.
