In Personal Finance, Choice Can Be a Tyranny
by Laura Rowley
Monday, December 21, 2009, 8:30AM ET - U.S. Markets open in 1 hr..
Laura Rowley Money & Happiness
Posted on Thursday, September 4, 2008, 12:00AM
I've officially been writing this column for three years, and covering personal finance for two decades. What I know for certain is that making the right financial decisions has never been harder.
Obscure Options
Part of the problem comes from the creative engine of consumer products and financial services, relentlessly generating new solutions to meet new needs. They offer so many different (and frequently shifting) iterations that it's often too time-consuming and complex to make an informed choice. Another part of the dilemma can be attributed to the corrupt underbelly of gotcha capitalism, which obscures the facts and tricks unsophisticated consumers into a host of expensive mistakes (think auto financing and subprime mortgages).
And often, the choices we must make don't translate in a meaningful way -- they don't tell us what we need to know. For instance, my health insurance came up for renewal over the summer, with a 26 percent increase in the premium. My insurance broker provided a side-by-side comparison of other plans; we talked about hospitalization, co-pays, and the ability to see doctors outside the plan. But it's virtually impossible to know what the policies would and would not cover if someone in my family got cancer. As a result, I defaulted to the status quo.
That's what most consumers do, and the widespread tendency to go with the default option creates an opportunity for better decision-making, according to Richard Thaler and Cass Sunstein, the authors of "Nudge: Improving Decisions about Health, Wealth and Happiness." Their proposal: Change the structure of the choice, and inertia will result in better outcomes -- higher savings rates, improved health care, and more organ donors.
The Architecture of Choice
Thaler, a behavioral economist at the University of Chicago, and Sunstein, who teaches at the university's law school, define a nudge as any aspect of "choice architecture" that changes people's behavior in a predictable way, without prohibiting options or significantly altering their economic incentives.
Calling themselves paternalistic libertarians, they say a nudge must be easy and cheap to avoid -- putting healthy foods at eye level in a school cafeteria vs. banning junk food, say, or making a diversified stock and bond fund the default choice for a 401(k) participant instead of a money market account.
And although the book is aimed at public policy, individuals can also nudge themselves. "We didn't write it as a self-help book, but it can be read that way," says Thaler.
Heuristics, Biases, and Anchors
In most decisions, people tend to rely on shortcuts and rules of thumb known as "heuristics and biases" that can skew our thinking. These were first articulated by psychologists Daniel Kahneman and Amos Tversky in the 1970s.
For example, the "availability heuristic" causes people to make skewed assessments of risk based on recent experience and memories. People who know someone who has experienced a flood are more likely to buy flood insurance for themselves, regardless of the flood risk they actually face.
"Anchoring" causes people to pay too much attention to an initial number or piece of information, and then adjust in a direction they think appropriate -- often when the anchor itself is random or arbitrary.
Big Decisions, Small Decision-Making
The first step to improved choices is to lay aside rule-of-thumb thinking when faced with a big decision that is rare, complex, difficult to translate in terms that can be easily understood, and doesn't offer immediate feedback. Invest time and money into getting independent advice, something most people don't do, says Thaler.
"I think you can get by OK with rules of thumb in lower-stake situations, but they don't end up working as well in high-stake situations," he notes. "People are used to using shortcuts, and on the big decisions they don't compensate enough. So they'll spend as much time choosing a TV as a mortgage, though the stakes are hundreds of times bigger."
When consumers do seek advice, he says, they tend to turn to people with conflicts of interest -- a mortgage broker or stockbroker working on commission. "It's the big-stake stuff people get the most wrong, such as mortgages and house-buying," says Thaler. "Some economists say if it really matters, people will take the time [to research] or get expert help. But people never get expert help in those domains -- at least expert help that's unbiased."
Choose Wealth
I asked Thaler for a few simple nudges anyone can do to boost their wealth. Here are a few:
• Pay off your mortgage before your retire.
"If you look at data from early 1980s, people in their 60s nearing retirement by and large had no mortgage debt," says Thaler. "The norm that you pay your mortgage off by time you retire has disappeared. It's a good self-control device to pay off the mortgage, and if you refinance, don't view it as an excuse for another vacation or some other kind of splurge. And if you do refinance, take a 15-year instead of 30-year mortgage, especially if you're in your 40s."
• Ask your credit card company to enforce the card's limit.
"Credit card companies don't do that because they say people don't want to be embarrassed by having card turned down," Thaler explains. "But most people carry more than one credit card. If you go over the limit by $50, they'll charge you by $50 and raise your interest rate by 300 basis points -- and you could have avoided the whole thing by saying, 'Oh, that card's capped out, use this one.'"
• Use the "mere measurement" effect to boost your goals.
Researchers have found that merely asking people about their plans affects what they do. "If you call them up and ask them if they're going to vote, they're more likely to vote; if you ask when they plan to vote and how they plan to get there, that works even better," says Thaler. "Whatever your goal is, announce it, make a specific plan, and then elaborate on it."
• Beware the pitfalls of "mental accounting."
While it's beneficial to allocate money for specific goals to separate accounts, strict observance can lead to unproductive behavior. A 2002 study of one group of consumers found the typical household had more than $5,000 in liquid assets (typically in savings accounts earning less than 5 percent a year) and nearly $3,000 in credit card balances, carrying a typical rate of 18 percent or more.
• Divest from your employer's stock.
If you hold a lot of your employer's stock in your retirement plan, create a nudge to sell 1 percent of the shares on a certain date of the month until you reduce your holdings to 10 percent or less. Five million Americans have more than 60 percent of their retirement savings in company stock despite the lessons of Enron and WorldCom. Thaler and Sunstein propose employers help workers with gradual divestiture, and they're looking for a firm willing to try out the plan. If your company is interested, contact the authors at their blog.
Cutting Through the Confusion
I asked Thaler about the subprime mortgage debacle, and the fact that poor choices were often made because lenders deliberately obscured information. The situation, he says, raises "a real question about how markets work," he says. "Some people have a naive view, that the invisible hand works when there is lots of competition. The winners will be the ones that provide the best products to people, and it can work out that way. But it can also work out that the winners are the ones that most successfully confuse people."
The solution is not more regulation, but more disclosure that allows for a clear comparison of the choices, as the authors wrote in a recent op-ed in the Wall Street Journal. They advocate electronic, machine-readable disclosure, "so when you apply for a mortgage, you could take that file and upload it to a website that would explain what you were buying," says Thaler. "It would allow the creation of third-party websites that would let you search better with more transparency."
Thaler cites the example of Morningstar and Lipper -- two companies that track and evaluate mutual funds, and exist only because funds are required to disclose performance, fees, and other information. "Machine-readable disclosure doesn't sound sexy, but has the potential to change the shape of gotcha capitalism," Thaler says.
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