In my Tuesday, October 10 blog post titled “Your Own Risk Tolerance”, I referenced “Nudge”, a book I recently read by Cass Sunstein and Richard Thaler. I had written that post a couple of weeks earlier.
Nobel Prize
Lo and behold, on the day prior, October 9, Richard Thaler was announced as the winner of the Nobel Prize in Economics. How great for Dr. Thaler, and how prescient of me! Dr. Thaler is a professor at the University of Chicago. His work has been very important to the fields of investing and financial planning.
Opt-In/Opt-Out
Dr. Thaler’s most famous and most significant contribution to financial planning is his recommendation that companies adopt an “opt-out” policy for its employees when they sign up for their 401k. “Opt-out” means the default position is that employees are in the 401k plan unless they choose to opt-out. Prior to Dr. Thaler’s recommendation, the default position was the opposite – employees needed to “opt-in” to the 401k. Companies that switch to “opt-out” find that their 401k participation rate rises dramatically, up to perhaps 90%. This is very important because qualified plans such as 401k need to meet “non-highly compensated employee” participation quotas. Whereas, under “opt-in”, companies may have had to cajole or further incentivize employees to enroll in the 401k, under “opt-out”, it is less of the problem to meet the quotas. It also means that more employees are saving for their retirements, which is a very good thing.
Save More Tomorrow
Another Dr. Thaler recommendation is Save More Tomorrow. With this, the employee starts in the 401k at a relatively low level of contribution. Perhaps the employee is young and has a commensurately low salary, or they really need the money today, or they expect they will have a long career with this company. Next year, the employee gets a raise. Dr. Thaler recommends you allocate your raise portion to your 401k, thereby increasing your contribution amount without cutting back on your take-home pay. Continue to live on your same net income, but save more for retirement. Employees should do this on their own even if their employer doesn’t offer a 401k or other retirement plan. It’s a good personal sacrifice and good financial planning.
Fewer is Better
Do you like going to a restaurant that has a huge menu? If so, is it easy or difficult to decide what you want to order? Maybe you have been to that restaurant before and you know what you want, or you know what is good there – you can choose what you want to eat without help. Or, are you like me, and you ask the waiter what’s good today? He may reply, “The salmon is especially good.” Often, I hardly look at the menu and rely only on the waiter’s (and the chef’s) good judgment.
If choice is good, then more choice is better, right? Well, not necessarily. Dr. Thaler noted that people often have a difficult time choosing and that adding to the number of possible choices only serves to add to one’s confusion. A restaurant that offers a smaller menu is effectively limiting the customer’s choices on purpose.
What do restaurants, salmon, and menus have to do with investing? Dr. Thaler’s work suggests that employers who offer 401k plans should limit the choices that employees have in allocating their contributions. Instead of offering 10 different large-cap growth funds and ask the employee to choose, only offer 2, but make sure both of the choices offered are strong funds with relatively low fees. By limiting choice, Dr. Thaler believes more employees will become engaged in their investments and will ultimately pay more attention to their own future needs. Same with financial advisors outside of 401k’s. Offer a choice, but only a choice of the best investments in your, the expert’s, opinion.
IMO
Dr. Thaler calls choice-limiting “Libertarian Paternalism”. I agree with the Paternalism part, but maybe not Libertarian. Like any theory, one can agree or disagree with all or part of it. With respect to investors and how they allocate their portfolios, Dr. Thaler’s findings are very helpful. It is a good thing if more people save and invest and learn how to allocate their portfolio, and it is a good thing that they increase their engagement with the investment world.
Next blog, I will discuss another Richard Thaler finding and how it relates to modern financial theory. There may be conflicting theories among Nobel laureate economists.