University of Chicago professor Richard Thaler just won the 2017 Nobel Prize in economics. He’s know as the father of behavioral economics. In perhaps his biggest claim to fame, you may have seen him in The Big Short.
He also knows why you handle your money the way you do — or, rather, why you don’t handle your money the way you should. And he has a suggestion for what you can do better.
What is behaviorial economics?
Economics is formally the study of the production, distribution and consumption of goods and services. Traditionally, that study has focused on how that cycle should work or would work best. But Thaler has been instrumental in explaining economics based on how people act in the real world. His branch of study — behavioral economics — basically tries to understand how and why people make the decisions they do. That way, it's possible to identify ways to course-correct. As this profile in The Washington Post says, “The [Nobel Prize] committee praised Thaler for trying to 'nudge' people and companies to make better decisions.”
How? By taking those decisions away from people.
Why we're bad at money
Think about your own financial life. How many things do you have automated? If you’re savvy, probably a lot. You might have money taken out of your paycheck automatically to be put into a 401(k) — and have that amount increase by a certain percentage every year. You might automatically have money invested in your IRA. You might even have your bills set up to be paid automatically.
Those are good habits for a few reason. First, we’re forgetful, and credit card bills slip our mind. Second, we’re really bad with money. As The New York Times notes, Thaler was instrumental in “establishing that people are predictably irrational — that they consistently behave in ways that defy economic theory.”
Saving for retirement is good for us, but half of U.S. families have no retirement accounts. Getting financial aid for higher education helps make it more affordable, but some people don’t fill out forms because they’re too complicated.
Thaler's solution: Automate everything
And that’s where institutions like companies and government can step in to help. For example, financial aid forms can be largely filled in for students. As Thaler himself wrote in 2013, businesses could encourage retirement savings by:
…mak[ing] payroll retirement savings plans available to everyone. Then, add empirically proven design features to them, making it easier for workers to make good choices. In other words, improve the plans’ choice architecture.
This extends beyond workplace retirement accounts. People are afraid to invest on their own because of market downturns. Thaler’s solution? Point them to the right kinds of accounts. From that same article:
A solution to bad market timing is to offer a default investment vehicle, like a target-date mutual fund, that automatically rebalances an investor’s portfolio, both cyclically as the market rises and falls, and as the client ages, reducing stock holdings as retirement approaches.
Thaler's work & your personal finances
Behavioral economics even plays a role in how we think about insurance. Take life insurance, for instance. It can be crucial for many people; if someone has a mortgage and wants to put their kids through school and hasn’t saved enough for retirement, life insurance makes sense. But, according to industry group LIMRA, 30% of U.S. households didn’t have life insurance in 2016. It’s easy to see why — no one wants to think about death, people may find their options confusing, and they think that life insurance is a gamble and they’re “wasting money” if they don’t die — but for many people it’s not the rational decision.
You may not know any other Nobel Prize winner, but you should remember Richard Thaler. More importantly, remember his lessons. You probably won’t make the right choices with your money, and that’s fine — as long as you do something about it. Take financial choices out of your hands. Don’t leave it to yourself to decide if you should drop money you don’t have on something you don’t need, or invest it in a 401(k) instead. Automate your life where you can so you don’t have any regrets later.
“My mantra is if you want to get people to do something, make it easy," Thaler said in an interview. Take the same approach and make things easy on yourself.