Through the emergence of Nudge Theory caused by Richard Thaler’s book and Nobel Prize in 2017, applications of nudges have been widely used, predominantly in the context of (neuroscientific) marketing to influence consumer decision-making. However, people often underestimate the impact of nudging in other aspects of the business environment. The following article focuses on both the negative and positive aspects of the implication of nudge respectively behavioral economic perspectives within the financial industry.
Regulation of Financial Markets/Regulatory Aspects
In light of recent financial scandals and crises, the government needs to improve the performance of regulatory authorities in detecting and preventing accounting and auditing frauds. One measure several governments started to use in recent years is establishing a behavioral science respectively nudge unit. The purpose of the aforementioned change to financial authorities is to consider the component of human or firm behavior when making regulatory decisions.
On the one hand, individuals are often subject to biases when encountering specific economic situations; regulatory authorities, thus have an enhanced understanding of the behavior of individuals when taking behavioral economic theories into account.
On the other, financial regulators need to recognize the risk that firms do not always comply with financial policies and regulations in a completely legal manner. By complementing the existing firm controls, especially audit processes, with behavioral insights, authorities are able to understand the sources and conditions of illegal actions more easily and can combat fraud more effectively. The ultimate goal of establishing behavioral science departments within the financial regulatory system is increasing investor protection and efficiency of policies. Frontrunners of these practices are the United Kingdom, Canada, and Singapore.
Financial/Investment Decision-Making
Tying onto the previous part, individuals often experience all sorts of nudges when facing financial decisions, for example, investment or retirement plan respectively saving decisions.
Investors are often prone to two types of biases (which you might have encountered as well if you are investing actively): loss-aversion and confirmation bias. Loss-aversion bias describes the effect that losses have a greater emotional impact on humans than the equivalent number of gains (part of Daniel Kahneman’s Nobel-prize-winning Prospect Theory). Confirmation bias explains individuals' susceptibility to overvalue information that supports their investment philosophy while discounting opposing evidence.
Being aware of them and implementing a question-based framework that always checks if an individual’s investments are still in line with the long-term strategy and goals can help to minimize their effect when facing financial decisions; however, one cannot fully eliminate their impact.
Regarding retirement plans and saving, default options and the present bias are two factors that often can lead to irrational, sub-optimal behavior. The default option leads humans to choose the preferred option without taking any conscious action. If they want to opt-out of this alternative, they have to take conscious actions. Consulting a related study, automatically steering a part of an employee’s salary into their retirement plan by setting this alternative as the default option, significantly increasing the number of people investing into their 401k or other forms of pension funds. This behavior can be explained by the paradox of choice: humans experience cognitive limitations when facing too many different options making them less likely to take any action. In the case of retirement plans, nudging in form of the default option is used for good which is aligned with Thaler’s idea and values of nudge theory. The present bias,however, leads humans to put more emphasis on current, immediate rewards while neglecting the long-term perspective. If we are being honest with ourselves, we all are guilty of this behavior: “I will start working out tomorrow but today I will treat myself again by eating fast food” or “I’ll start studying tomorrow but today I am going out partying one last time” are examples most of us can relate to.
These same bias haunts individuals when thinking about saving for our retirement. When starting saving early, an individual does have to make compromises, sacrificing vacations or expensive restaurant trips for instance, but because of the compounding effect, commencing to save money just two or three years earlier can lead to substantial differences in one’s retirement funds. To combat this bias, Thaler himself created a campaign that promotes retirement savings, leading to an additional $30bn in pension funds.
Financial Advisory
Having discussed the positive effects of nudging in finance in the previous paragraph, nudge interventions are often misused in the context of financial advisory. Due to an inherent conflict of interest between the expected return of a client and sales commission, financial consultants often use nudging techniques to influence the customer’s decision. Prioritizing his or her own sales targets, the advisor does not act in the client’s best interest, potentially leading to sub-optimal decisions.
Common nudging techniques used to affect the decision-making of customers are limiting the availability frame and available alternatives of investment products. In times of emerging Robo-advisories, nudging is still important, as even these FinTechs are starting to implement techniques that exploit humans' behavior limitations.
Impact Investing
As impact investing is more important than ever in today’s world, governments are trying to incentivize these forms of investments, both for private investors and institutional investors respectively enterprises.
On the one hand, there are many different schemes of how impact investing should be awarded by financial compensation. Although highly successful, this does not correspond with the main idea of nudging which states that an individual’s behavior should be influenced without changing their economic stimulus significantly.
On the other, there are projects which do not rely on monetary rewards but rather focus on other aspects where potential impact investors can benefit from; establishing a marketplace for “impact auctioning”, for example, would enhance the availability and transparency of impact investments, while a blockchain technology specifically designed for impact investing could improve the reliability of related data and regularity respectively consistency of impact measurement.
Conclusion
As illustrated above, nudges are widely spread in the world of finance. As there are certainly ways of misusing nudge interventions, when utilizing them for good, as they are intended to, they can have a substantial positive effect. While the above-mentioned nudge examples depict the use of BE in the financial system well, it is important to say that nudging techniques are not limited to these fields of finance. An additional entire article could be dedicated to the topic of how behavioral economics can influence sustainable financing, meaning impact investments, meeting ESG criteria, and respecting UN SDG goals, as this trend is arguably the most prominent in today’s world of finance and will only gain in importance in the immediate future.
Author
Daniel Maurice Konter
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