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The nudge and the anti-nudge

Nobel laureate's ideas can be used to improve choices in personal finance. Or can they?

The nudge and the anti-nudge

A few weeks ago, the American economist Richard Thaler became the winner of the 2017 Nobel for Economics. The award was 'for his contributions to behavioural economics,' something most of us can connect to in our own lives. Usually, this is not the case, and the prize is given for work that is not directly usable in our everyday lives. Last year, for example, it was given for 'contributions to contract theory', before that for 'analysis of consumption, poverty, and welfare'.

Thaler's work is different. The 'default choice' idea, which is the first principle of 'choice architecture' also works very well in a variety of ways in savings and investments. For example, this lies at the heart of the extraordinary efficacy of the SIP (Systematic Investment Plan) as a way of investing regularly and generating great returns from equity funds.

The most frequent reason that investors get poor returns from relatively volatile investments like equities and equity funds is that they stop investing, or even disinvest, when markets drop. This is a natural reaction to the fact that the media presents falling stock prices as a crisis. However, this makes no sense. Whether you are buying shirts of stocks, lower prices are always better, provided you are buying quality stuff. SIPs solve this problem through being the kind of 'default' option that Thaler's Choice Architecture contains. In SIPs, the default is to continue investing. Stopping it requires an action. Otherwise, the default is to not invest, and making an investment requires action. The difference in outcomes is obvious.

Thaler's idea of a 'nudge', which is also the title of a popular book he co-wrote, is something that we can use to modify our behaviour in matters both money-related and others. It all boils down not to the choices themselves, that how choices are framed and how they are presented. For example, Thaler has said that the Brexit referendum in the UK could have gone the other way by just some changes in the language on the referendum ballot.

Not just after the Nobel, even earlier, there was a lot of interest around the world on how governments can use appropriately designed nudges to help people make better choices. This is true not just in matters related to personal finance and savings, but in many other areas as well. For example, the UK government has something called the 'Behavioural Insights Team', which is unofficially known as the government's 'Nudge Unit'. This unit is headed by a psychologist and has suggested a number of actions that the government has taken. These range from measures that increase the tax payment rate to reducing prescription errors in hospitals. By the way, back in 2012, the Government of India also tried to nudge people into equity investing by launching a bizarre scheme (Rajiv Gandhi Equity Savings Scheme) whose nudge action was to get lots of demat accounts opened. Needless to say, it came a cropper.

All this nudging makes it sound like an easy and straightforward thing to do, especially in investments and savings. However, there is always a however. The problem is that even before nudges are being talked about, there are plenty of anti-nudges that have been deployed by those who stand to make money out of your personal finance decisions. It is an almost inviolable rule of personal finance that decisions that are better for savers and investors lead to lower income for financial intermediaries. If something nudges you to tell an insurance agent that you need to protect your family, you'll get a suggestion for a high-commission ULIP or endowment policy instead of the term insurance you actually need. If you have a large lump sum to invest, you will get a suggestion to put it all at one go in an equity fund rather than an SIP because the former choice means a large immediate payout for the fund salesperson. As for the advice that is handed out for stock investing by brokers, the less said about it the better.

All in all, the sellers and the advertisers of the world have cottoned on to Thaler's ideas, probably long before Thaler himself got these ideas. At the end of the day, it's hard to do things that will reduce someone else's income because your nudge will get a much stronger anti-nudge. The idea of nudge is basically about manipulating people with good intentions. In practice, only those who have enough knowledge and motivation to nudge themselves will have good outcomes.