Richard Thaler was recently honored with the Nobel Prize in Economics for his pioneering work in human behavior, specifically for establishing that people are “predictably irrational.” But the story of Thaler’s first insight into what would become behavioral economics and finance is famous and instructive.
It was the late 1970s, and Thaler hosted a dinner party for his fellow economics students. He set out a bowl of cashews for his guests to nibble on while waiting for dinner. Thaler noticed, however, that the cashews were disappearing quickly into the mouths of his hungry guests. Concerned that they would be full by the time dinner was served, Thaler took away the bowl.
This experience gave Thaler insight into the difficulty of exercising self-control. The supposedly rational economists at the party knew that dinner would be served soon, yet could not muster the self-control necessary to refrain from filling themselves with cashews.
Thaler’s studies into self-control and human behavior ran contrary to the economic theory at the time — that people are rational. Of course, rational people would have no trouble exercising the self-control necessary for refraining from eating too many cashews. But Thaler’s work recognized that people are not usually rational and they need tools to help them exercise self-control.
At Thaler’s dinner party the “tool” was simple: just take away the bowl of cashews.
Thaler’s research into human behavior led to a tool that has helped millions of Americans improve their chances for financial security in retirement: automatic enrollment into retirement savings programs. With this system, employees are automatically signed up for the plan and have to opt out if they are not interested in participating. As of last year, 58% of companies offering a retirement plan provide automatic enrollment1.
Thaler has also been credited with auto-escalation, where retirement plan participants automatically and incrementally increase their contributions to their plan. In addition, his research around ownership, fairness, and confidence have also influenced how governments make decisions.
I came to know Thaler’s work when I arrived at Santa Clara University in late 1979. There I met Hersh Shefrin, who had been working with Thaler on self-control. As Hersh and I worked together, we found that investors bolster their self-control by framing their money into separate mental accounts, one for income and one for capital, and use a rule — “spend income but don’t dip into capital” — to prevent spending too much and saving too little.
Working closely with your financial advisor is another powerful way to help you exercise self-control. As you collaborate on your long-term goals, develop a written plan designed to help you achieve them, and construct and adhere to an Investment Policy Statement, you increase your likelihood of making wise financial decisions and staying on track.
By Meir Statman