Behavioural Finance

Jindal School of Banking and Finance

April-May, 2024

Lecture 5: Choice Architecture and Finance

Amlan Das Gupta
In this lecture:

 What is a nudge?
 A discussion of the ethical issues with nudges.
 Needs to regulate.
 Fools and fooling as a profession.
 Choice architecture examples
Psychology is powerful
 Psychology seems innocuous but wields considerable power.

 It may influence the economy, government, elections and individual

lives.

 Very hard to resist.

Situations where it can help
 The book on Nudges by Sunstein and Thaler document the
idea of using these concepts to help people make better
decisions.

 Improving savings and investment decisions.

 Health and environment.

 Personal choices.
Choice Architect
 Defines choice architect as someone who uses behavioural nudges to
engineer certain choices.

 Libertarian paternalism. “paternalistic” if it tries to influence choices

in a way that will make choosers better off, as judged by themselves

 Careful not to adopt a command and control approach.

 Easy opt-out options.

Reasons to worry
 May be the beginning of a disturbing trend leading to more draconian
measures.

 However as long as the intention behind the nudge is good this should
not be a problem.

 As long as opting out is relatively low cost.

 No nudge is a nudge to maintain status quo.

Conflict of interest

 Choice architects may promote their own interest while designing

nudges.

 The response is to call for transparency regarding the intentions of

choice architectures.

 Also, there should be a system of reporting of the level of different

consumptions with and without the nudge.

 But is this enough … ??

Counter–arguments: Right to be wrong

 “Let me learn from my own mistakes”!!

 Some may not be able to survive a mistake.

 Social costs of recovery for example failures of the financial system.

Counter-arguments: Anti-redistribution

 Nudges imply a cost for rational individuals.

 These are generally richer people with time and education on their side.

 This implies that a choice architecture for better choices is like a

redistribution.

 Why not just provide lots of choices and force people to choose?
Is redistribution bad?

 Adam smith assumed that people take happiness being looked at favourably by
others.

 There is also a view that people derive happiness from being richer than other
people.

 There might also be public good characteristics of redistribution.

Subliminal advertising
 We have seen that nudging and availability heuristics often work
without us even knowing it.

 Advertising that works under the radar can be disconcerting.

 We are often defenceless against this.

John Rawls (1971), the publicity principle
 Rawls: The government should not take up a policy that
they would not be able to defend in public.

 Think about some of the policies or nudges that you don’t

agree with.

 Will they satisfy Rawls’ principle?

Neutrality
 Neutrality is impossible in general.

 Sometimes neutrality may be mandatory like in voting.

 In some cases when the correct direction of nudge is apparent, neutrality is

undesirable. Example: Encouraging of savings.
Emergence of professional nudgers

In their book Phishing for Phools Akerlof and Shiller put forward the idea that given our
economic system we should expect deception.

 In a free market agents are free to choose what they want to do.

 If phishing is lucrative that is what they will do.

 So phishing is an equilibrium of the market.

What to do
As phishing emerges as an externality it is recommended that the government
should step in to correct this:

1. Force people to save.

2. Regulation of financial securities.
3. Control over campaign contributions.
Inadequate Savings
The saving problem
 Economic theory expects people to rationally calculate the amount they want
to save each period throughout their lives.
 However, consumption is a temptation good.
 Also, people don’t have the supercomputer-like ability to do the math
Indian Savings rate
Indian Savings rate
 According to our economic survey the Indian savings rate has been falling.

 India’s gross savings fell to 30.1 per cent of the gross domestic product in
fiscal 2019 from 34.6 per cent in fiscal 2012, and 36 per cent in 2007-08,
(Central Statistical Organisation).

 However, we are still way ahead of the USA(0%), Europe (about 20%).

 Are we moving towards the US??

Reasons to worry
 Some countries are by nature good savers. Example: Japan.

 Indians may be good savers but we are only just getting properly
exposed to temptation.

 As the financial system expands we are going to have access to more

credit.

 In 1980 the US savings rate was above 10%.

Take away from economic theory

 The thinking in mainstream economics is that savings is a rational

choice.

 In each period people compare the benefit of saving a rupee to the cost
of it.

 If there is any additional income it will not lead to a spike in current

consumption.

 There is consumption smoothing over the life-cycle.

Resisting Temptation

 The thinking in mainstream economics is that savings is a rational

choice.

 People need to commit to a plan and stick to it.

 This gets difficult for a multi-period plan as current consumption is a

“temptation good”.
Temptation goods

 Situation A: At the start of semester make a plan to complete your term

paper a week before the deadline.

 Situation B: It is a week before the deadline, you are considering if you

should work on the paper.

 The good is enjoying leisure and the two states are called hot and cold.
Another example

 You need to chose the menu for dinner you want to eat healthy.

 Situation 1: You are on new years day making the resolution. (cold)

 Situation 2: You are in front of the desserts tray in some wedding feast.
(Hot)
Temptation goods definition
 Temptation goods are those that we tend to choose more of in a hot
situation.

 These goods typically demonstrate a dynamic inconsistency in

preferences.

 As such it is impossible to make commitments a priori regarding these.

 Consumption is a typical example.

Reasons for the inconsistency
 George Loewenstein (1996) : “hot-cold empathy gap.”

 Our cold state self does not empathize enough with our hot state self.
Framing problems
 Savings is a complicated decision.

 However usually system 1 has to take these decisions.

 As we have seen before this decision will be biased.

 Often mental accounts are used to take this decision.

Experiment: Shefrin and Thaler

Respondents are asked about their consumption plan in case they receive
$2400 under the following circumstances:

 Bonus at work paid at $200 /month. – Median respondent spends $100

a month.

 Lumpsum - $400 spent upfront and the $35 every month for a year.

 An inheritance to be received after 5 years in a savings account –

Nothing spent this year.
Keynes and animal spirits
 A major prediction of current thought in economics is that savings will not spike in
response to cues.

 However the variability in savings in the US belies that prediction.

 This is closer to Keynes’ idea that the marginal willingness to consume of a dollar is
constant.
Guarding against temptation

 Most people know about the problem.

 People are willing to pay for measures to curb temptation.

 Odysseus’s plan against the sirens.

Dan Ariely’s students
Ariely uses three papers in his class as assessments:
 The firsts section he allows the students to choose the submission dates which become
fixed once chosen.

 The second section sets them the last day of class as the deadline.

 In the third class he imposes equally spaced deadlines.

Take-aways
 The best way to handle temptation is a command and control approach

 If not, giving the students an avenue to control helps.

Savings in a country

 Nowadays there is a lot of variation in saving rate for different countries.

 Some countries have very high savings rate leading to high growth.

 Example: Singapore, China, Japan.

Savings policy

 The Singapore government mandates almost 50% of an employee's pay is to be

contributed to the Central Provident Fund.

 The most countries use tax benefits to promote savings.

 Some countries are culturally spenders. 1.3 billion credit cards in the US opposed to 5
million in China.
What can be done?
 Retirement savings and rates should be presented as opt-outs.
 Commitment devices to increase savings in tune with incomes.
 While a command and control approach seems unethical, a choice
maximization approach may not be ideal either.
Money illusion
Money Illusion – Animal Spirits by Akerlof and Shiller

A no smoking sign on a Boston commuter train noticed by Shiller –

“Punishable by imprisonment up to 10 days or fine up to 50 dollar or both”

If given a choice which would you choose?

Consequences of the illusion
 Wages often tend to remain unadjusted.

 Financial instruments also fail to make the adjustment.

 Nominal borrowers will benefit lenders will lose out.

 Example US elections in 1896.

Fisher’s book
 Irving Fisher in 1928 wrote Money Illusions which highlight the
mistakes people make.

 The story of Cora and her investments.

 Ties into Fisher’s work with interest rates.

Reasons for the illusion
 Inflation indexing can lead to downward adjustments in price.

 Future payments are discounted, we don’t care about them so much.

 May seem unfair.

Key assumption
 The most important assumption in the natural rate theory is the lack of money
illusion.

 However, there is a lot of evidence that money illusion still prevails.

 This is true both in finance and in the labour market.

Money as a unit of account

 Money is the unit in which all contracts are specified.

 Money is also the unit in which accounts are maintained.

 Many legal provisions specially related to taxation are in terms of money.

Money illusion in wage contracts

 The biggest evidence is that people hate to take wage cuts in times of
depression.

 Careful studies have documented such wage stickiness in Australia, Canada,

Japan and many other countries.

 In the great Canadian depression of 1992-94 inflation fell to 1.2%, yet 47% of
union contracts had wage freeze, only 5.7% accepted a cut.

 This boils down to loss aversion and reference points.

Money illusion in debt contracts

 All government bonds are unindexed.

 Mortgages are also similarly not inflation adjusted.

 Is it possible that after rejecting an inflation adjusted contract people

correctly adjust their final payments for inflation?
Calculating Compound Interest
Power of Compunding
 The compound annual growth rate for the BSE SENSEX in India over the
period 1979-2017 is about 13%.

 If as a young professional (20 years) you invest INR 1,00,000/ year in the
basket of the SENSEX for 10 years.

 At the age of 65 years you will have more than 13.5 crore.
Miscalculating

16

14

12

10

8 Compound
Simple

0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29
Mistakes in Investing

 People invest less, and use bad quality information.

 Not opting for retirement savings plans.
 Churn their portfolios.
 Invest in similar stocks because they are all doing well.
 Investing in your own company.
What can we do?

 Change default options.

 Simplify complex choices.
 Mapping and feedback
 Working out incentives.
readings

 Chapter 6 The Problem of Procrastination and Self-Control

– from predictably irrational, Dan Ariely

 Chapter 10 – Animal Spirits.

 Chapters 2 and 6 - from Nudge

Readings

 Nudge – Thaler and Sunstein

 Ethics of Influence - Sunstein