This article is an excerpt from the Shortform summary of "Nudge" by Richard H. Thaler and Cass R. Sunstein. Shortform has the world's best summaries of books you should be reading.
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What are behavioral biases in investing? How does Nudge suggest addressing them?
Biases in investing are the psychological obstacles that prevent you from making rational decisions. Adjustments, like nudges, can encourage better choices.
Keep reading to see how biases in investing might be hurting you.
Nudges to Address Biases in Investing
Not very long ago, the most common retirement plan offered by employers was a “defined-benefit” plan—that is, one that made fixed payments to the beneficiary based on tenure and salary. Now, the most common type of retirement benefit is a “defined-contribution” plan, which consists of contributions made to a tax-sheltered investment account.
With this shift has come a greater decision-making burden on workers. What level of risk am I willing to take, and how do I allocate my savings accordingly? Should I be investing in stocks or bonds or both? How often should I revisit my allocation of assets, and what real-world information should I be looking for to know when to change it? Behavioral biases in investing impact the choices made.
If we were Econs, we would have no trouble (1) recognizing that stocks outperform bonds historically and (2) calculating our tolerance for risk based on the probability distribution of stock-market returns. But, because we’re Humans, the complexities and variability of defined-contribution plans tend to bring out harmful cognitive and behavioral biases in investing that end up—quite literally—costing us.
One cognitive bias that is especially common is the bias of loss aversion in investing (see Chapter 1), which results in overreactions to short-term market fluctuations. For example, Humans will fixate on the monthly, weekly, or even daily movements of the market and potentially change their asset allocations on those bases—when, in fact, these fluctuations belie the long-term upward trend of the market. Case in point: A study of retirement plans administered by Vanguard showed new enrollees allotting 58% of their account to stocks in 1992, 74% by 2000 (when tech stocks were booming), and 54% by 2002 (after the tech bubble burst). In other words, these employees bought high and sold low—the exact opposite of what they should have done. Loss aversion in investing stopped them from making rational decisions.
In addition to loss aversion in investing, there are other heuristics and biases in investing. Humans also tend to resort to rules of thumb when it comes to investment decisions. One such rule is “When in doubt, diversify.” But “naive diversification”—e.g., splitting your asset allocation 50/50 between stocks and bonds; or, when faced with more than two options, dividing your money up evenly between the several choices—can be just as detrimental to your retirement account as loss aversion. For example, if you divide your assets equally among three bond-heavy funds and one that’s split 50/50 between stocks and bonds, your investments actually aren’t diverse—you’re overallocated to bonds.
(It’s important to note that, overall, diversification is a good thing. Take, for example, investing in your own company’s stock: Economist Lisa Meulbroek found that a dollar invested in company stock is worth less than 50% of a dollar invested in a mutual fund! Enron and WorldCom employees who poured their retirement savings back into company stock learned this lesson the hard way.)
Better Defaults
As with saving in general, investment decisions can be improved with defaults that are more sensitive to Humans’ tendency to err.
One such default is to automatically enroll employees in a “target maturity fund,” which determines its asset allocation on the basis of its investors’ prospective retirement age. Another slightly less automatic option is to give employees “lifestyle” portfolios—conservative, moderate, and aggressive—that comport with their tolerance for risk.
Better Choice Structure to Correct Biases in Investing
Rather than offer a wide range of funds with obscure names and numbers and voluminous literature, plan sponsors can offer “tiers” of choices that cater to employees’ desired level of involvement in their investments. Tier 1 would be the default—a “target maturity” or other “managed account” tailored to the employee’s age. Tier 2 would offer a small number of funds with different asset allocations among which the employee could choose. Tier 3, intended for the savviest investor, would feature the full complement of funds.
Better Error Anticipation
Plan sponsors should expect people to forget about their accounts and fail to rebalance their allocations. Thus, along with automatic enrollment, plan sponsors should automatically adjust people’s asset allocation over time.
Better Mapping and Feedback
A glut of numerical values—rates of return, interest rates, risk ratios—can stymie even the most sophisticated investor. (Sunstein himself admits to balking at the difficulty of retirement-fund allocations.) One way to prevent confusion or resistance in enrollees is to translate the jargon and number values into easily digestible concepts.
For example, rather than bombarding investors with statistics and disclaimers, plan sponsors can attach lifestyle images to particular levels of retirement income. For one level, the image might be of a small, sparsely furnished apartment; for a higher level, the image might be a house with a swimming pool.
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- Why subtle changes, like switching the order of two choices, can dramatically change your response
- How to increase the organ donation rate by over 50% through one simple change
- The best way for society to balance individual freedom with social welfare
