It’s not always easy to do the right thing. So why not make the right thing the easy thing?
That’s the idea behind a technique from the behavioral sciences known as a “nudge.” Broadly speaking, a nudge is a way of framing choices that subtly favors the more desirable outcome. It can be a way of encouraging people to do what’s in their best interest, even when other perfectly human tendencies—such as the urge to procrastinate—are conspiring against them.
Governments and companies use nudge theory to encourage people to make socially desirable or individually beneficial choices, whether the goal is to boost organ donation or get people to save more for retirement. And these techniques can work, as we’ll see below. The good news for investors is that the ideas behind nudges can help people make better saving and investing decisions for themselves, even without outside involvement.
Here we’ll look at how nudges work and offer some tips investors can use to bring this technique to bear on their portfolios.
Anatomy of a nudge
Nudges had their moment in the public spotlight thanks to the book “Nudge,” by Nobel Prize–winning economist Richard Thaler and law professor Cass Sunstein. The book explains how findings from the worlds of psychology and behavioral science could help people make better choices with their money, health and other issues. Several countries have since set up “nudge units” to inject such thinking into public policymaking.
Thaler and Sunstein explain that people have two modes of thinking: The reflective system, in which longer-term, more deliberative thought happens; and the automatic system, where quick, instinctive decisions are made. Unfortunately, these two systems don’t always cooperate. The automatic system likes the status quo and tends to shy away from anything that might delay gratification—which can lead to decisions that might feel good in the moment, but aren’t good for our longer-term prospects. So, whereas our reflective system might grasp the need to save for retirement, our automatic system insists on another dinner on the town with a promise to save more next month.
That’s where nudges can come in. If you can frame a decision in a way that makes it easy for the automatic system to gravitate toward the more desirable choice, you can set yourself up for success. It’s a question of putting the best outcome along the path of least resistance and letting the automatic system do its thing.
Opt in/opt out
A common nudge is to reframe opt-in/opt-out defaults for programs that involve enrollment decisions. Organ-donation programs in Europe offer an example. One study found that countries where people have to choose to become organ donors—say, by filling out forms, making calls or mailing documents—end up with far fewer registered donors than countries where adults are automatically registered as donors but can choose to opt out.1 Opt-in countries such as Denmark, the U.K. and Germany all had participation rates below 18%. In contrast, opt-out countries such as Austria, Belgium, France, Hungary, and Poland had participation rates of 98% or above.
In all cases, adults were free to choose whether to become donors, and the differences weren’t based on cultural preferences or educational campaigns. In fact, the study notes that the Netherlands, which had an opt-in system, launched an extensive campaign to boost organ donor registration—with little effect.
The opt-out countries simply realized that when the brain’s automatic system meets some paperwork or a bit of effort, it tends to recoil. Stacking that paperwork in front of the exit rather than the entrance can help keep enrollment high.
Companies have had similar results with 401(k) programs. A study of four companies found that asking employees to opt out of 401(k) programs instead of opting in boosted participation rates for new employees from less than half to almost 90%.2
Other kinds of nudges can also boost savings. For example, asking workers to commit to saving pay raises can also encourage them to save more.3 Adjusting the default savings rate and employer matches can also help overcome procrastination and prompt more saving.4
Again, these are all examples where a thoughtfully designed default option—the easier option—helped people save more without forcing their hand or taking away their freedom to choose.
Investor, nudge thyself
Nudging is a powerful idea—which is all well and good if you’re already being nudged. But what if you want to nudge yourself? You have some options.
After all, saving and investing can be kind of like striking a deal for your future self. Every dollar you invest is a dollar you can’t spend today—but the payoff in the future could be worth it. So why not make it easier to save with a nudge? Think of it as your future self nudging your current self. Then again, it also works in reverse: Your reflective system probably already knows you have to save, so how can you nudge your future self to stay on track?
Here are some ideas:
- Lean into the nudge. If you’ve already automatically been enrolled in a 401(k), stick with it. And if you really want to lean in, take the default savings percentage and go a little higher—say an extra percentage point.
- Use automatic contributions. This may already be a feature of your 401(k) account, but you can also use it with other kinds of investments or savings accounts. Setting up automatic contributions, say, on a monthly basis can help you accumulate savings and take advantage of strategies such as dollar cost averaging. And most importantly, it can pre-empt an urge to delay saving.
- Use annual step-ups. Consider increasing the contributions to your savings and investment accounts over time. One approach developed by Thaler and the behavioral economist Shlomo Benartzi asks participants to commit to saving pay increases.5 Or you could just boost your 401(k) contribution by a percentage point each year.
- Be specific about your goals. A large body of research shows people who set concrete goals that are difficult to achieve end up doing better than those set unambitious or vague goals.6
- Create prompts for yourself to rebalance and review. Use your mobile device to send yourself annual reminders to revisit your financial plans, think about your goals and risk tolerance, and, if necessary, rebalance your portfolio.
- Draft a trading plan before trading. If you’re a stock trader, think about committing to a trade plan that restricts how much you’re trading and sets price thresholds that can help you keep your emotions at bay when markets shift. Think of your plan as a set of guardrails that can keep you honest.
1Eric J. Johnson and Daniel Goldstein, “Do Defaults Save Lives?,” Science, 11/21/2003.
2Brigitte C. Madrian and Dennis F. Shea, “The Power of Suggestion: Inertia in 401(k) Participation and Savings Behavior,” National Bureau of Economic Research, 5/2000.
3Richard Thaler and Shlomo Benartzi, “Save More Tomorrow: Using Behavioral Economics to Increase Employee Saving,” Journal of Political Economy, 2004.
4James J. Choi, David Laibson, Brigitte C. Madrian, Andrew Metrick, “Saving For Retirement on the Path of Least Resistance,” National Bureau of Economic Research, 7/2004.
5Richard Thaler and Shlomo Benartzi, “Save More Tomorrow: Using Behavioral Economics to Increase Employee Saving,” Journal of Political Economy, 2004.
6Edwin A. Locke and Gary P. Latham, "Building a Practically Useful Theory of Goal Setting and Task Motivation," American Psychologist, 9/2002.
What you can do next
- Listen to more episodes of Choiceology, a podcast about the psychological traps that lead to expensive mistakes.
- Do you trade frequently? Enroll in Schwab Trading Services and review your trading plan with a Schwab trading specialist.
- Need help planning for retirement? Consider Schwab Intelligent Portfolios Premium™, our unique approach that combines professional advice with automated investing.