Behavioral Economics

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Behavioral Economics: How Using This New Science Can Triple Your Savings Rate

By Dr. Mark Skousen, Chairman, Investment U
Monday, August 21, 2006: Issue #573

“The human mind is charming in its unreasonableness, its inveterate prejudices, and its waywardness and unpredictability.” - Lin Yutang, The Importance of Living

Answer quickly the following four questions:

1. Are you constantly surprised by the size of your credit card bill?

2. Do you live in fear that you haven’t saved enough for retirement?

3. Do you often find yourself buying stocks at the top and selling at the bottom?

4. Have you failed to update your last will and testament?

If you answered “yes” to some of these questions, join the crowd! Most of your fellow investors are in the same boat.

Fortunately, help is on the way, at least for two of the problems listed above: overspending, and not saving enough for retirement.

In this issue we’ll discuss the new science of behavioral economics and how it can help investors secure their financial futures. But first, we’ll take a look at what has brought this important investment philosophy to the workplace.

Behavioral Economics Enter the Workplace With A Little Help From Washington

Last week, President Bush signed into law the Pension Protection Act that encourages workers to spend less and put more of their money into their 401(k) and IRA plans.

A small change in the law will have a BIG impact: For the first time, employers will automatically enroll workers in their 401(k) plans.

Workers can choose not to participate, but they must specifically request exemption. This is the opposite of what was the norm in employee benefits. In the past, workers had to sign up for their 401(k) plans to participate, and, on average, only half did.

In addition, there is a mechanism to increase gradually the amount saved, and employers are encouraged to match some of the dollars that workers invest each year. For example, if workers get a pay raise, some of that wage or salary increase will automatically go into their 401(k) investment plan.

The New Field of Behavioral Economics, and What It Means To Your 401(k)

These two new pension ideas are the brainchild of Richard Thaler, professor of economics at the University of Chicago and father of the hot new science called “Behavioral Economics.” (Another breakthrough by Chicago economists!) Essentially, Thaler and other behavioral economists argue that investors, consumers and business people don’t always act according to the standard “rational behavior” model in economics. Instead, people often suffer from overconfidence, overreaction, fear, greed, herding instincts and other “animal spirits,” to use a term from John Maynard Keynes.

For example, as noted, consumers overspend and undersave in today’s inflationary consumer society. Thaler proposed several institutional changes to encourage more saving…

In the late 1990s, he began an experiment called the “SMART” savings plan with five corporations in the Chicago area. He convinced these companies to adopt his plan to have workers enroll “automatically” in their 401(k) investment plans. Traditionally, most corporations treat 401(k) plans as a voluntary program and, as a result, only half of employees choose to sign up. In Thaler’s plan, employees are automatically invested in their 401(k) plans unless they choose to opt out.

The result? Instead of 49% signing up (as they do in a typical corporate investment plan), 86% participate!

How to Triple Your Saving Rate Painlessly

In addition, Thaler also required workers to automatically invest most of their pay increase in higher contributions to their 401(k) plans. With the pay raise, workers see their take-home pay go up, but so does their 401(k) investment rate. Consequently, employees under this SMART plan have seen their average personal savings rate increase from 3% to 11%.

Now we’re going to see the same results on a nationwide level. And a higher national saving rate will translate into higher economic growth rates. It’s a win-win situation.

I urge all of you to apply the Behavioral Economics model and take full advantage of this new plan whether you run a company or work for one.

Good trading, AEIOU,

Mark

Today’s Investment U Crib Sheet

Want to know more about the new theories of behavioral economics? Pick up a copy of Why Smart People Make Big Money Mistakes, by Gary Belsky and Thomas Gilovich. I also discuss it in my book, The Power of Economic Thinking, available on Amazon.