Behavioral Economics Mitigates Investor Suboptimal Choices Through Choice Architecture

Key Quotes

"So, you know, when we observe behaviors, whether it's good, better, ugly, whether it's intentional behavior or errors of omission, let's say, the question is always, well, why did they make the choice they did? And I think that's the fundamental question at the heart of behavioral economics is, why do people act the way they do? And in particular, why do they deviate from what the likes of Joe and other economists would predict?"

Andy Reed explains that the core of behavioral economics is understanding the reasons behind people's actions, especially when those actions differ from what traditional economic models would suggest. This field seeks to bridge the gap between theoretical economic predictions and actual human financial behavior.

"So rather than trying to fix the person, the key insight was, let's fix the environment. Let's fix the decision architecture so that the right choice is the easy choice. And in fact, it's the default or automatic choice. So rather than trying to educate people and convince them and persuade them, which is really quite challenging, they automated enrollment in the 401k plan. They automated investment through a target date fund, and they automated increases in the savings rate over time."

Andy Reed highlights the success of the "Save More Tomorrow" program as a prime example of applying behavioral economics. Instead of focusing on changing individual investor psychology, the strategy involved redesigning the system to make the desired behavior the default and easiest option. This approach led to significant increases in retirement savings.

"The other end of the spectrum that we see, it's less about thinking too slow, it's about not thinking or not engaging at all. What we find, in particular, we find cash sitting in retirement accounts where you wouldn't expect it and where economists would say it should not belong. Imagine a 25-year-old who had their first job, they worked there for, let's say, three years straight out of college, and they do a rollover and they roll the 401k assets into an IRA. It turns out that many of them, if not most of them, leave it in cash for extended periods of time. In our research, we found that often up to seven years or more."

Andy Reed points out that while some investors react too quickly to market events, a more prevalent issue is inaction or disengagement. He uses the example of young investors leaving rolled-over 401k assets in cash for many years, missing out on potential market growth. This demonstrates a significant opportunity cost due to a lack of engagement.

"One of my favorite paper titles of all time is 'Trading is Hazardous to Your Wealth.' And basically what they showed is that the people who trade more actively have worse performance, worse returns. So they're undermining their long-term goals. Now, you might argue, well, maybe they're garnering some emotional utility, maybe it's just fun. But there's a difference between a little bit of trading with a little bit of your portfolio and then making risky bets with your nest egg on a regular basis."

Andy Reed references research indicating that frequent trading negatively impacts investment returns, suggesting it is detrimental to long-term financial goals. He distinguishes between occasional, perhaps emotionally driven, trading and making substantial, risky bets with one's primary retirement savings.

"I have to say inertia and status quo bias. I, I think it's just, you know, again, most people do nothing almost all the time. And, you know, and it, and it doesn't matter. It doesn't matter whether it's your 401k or IRA or HSA, many, you know, brokerage account, you name it. And the question is like, what's happening while you're doing something else? And by the way, it's, it's often not willful inertia. It's just you're dealing with life. You're doing a podcast, right? There's, there's things that get in the way."

Andy Reed identifies inertia and status quo bias as the behaviors that most significantly impact investment outcomes. He explains that most people tend to do nothing with their accounts, not necessarily out of deliberate choice, but because life's demands take precedence. This inaction, even if unintentional, can lead to missed opportunities.

"Check your blind spots. Just again, like in driving, if you change lanes without checking your blind spot, you're going to have a bad time. So I think just like looking at your account and making sure is this what you intended it to be? Because either because, you know, again, you forgot or maybe the market drifted and that 60/40 portfolio that you set up so carefully and deliberately 10 years ago is now, I don't know, 80/20 and you didn't want it to be 80/20, but you didn't realize how drift works."

Andy Reed advises investors to regularly check their "blind spots," drawing an analogy to driving. He emphasizes the importance of periodically reviewing investment accounts to ensure they still align with original intentions, as market fluctuations can cause portfolios to drift from their target allocations without the investor realizing it.