Does Behavioral Finance Actually Work?
Yes, but only when the choice of inaction is removed
I’ve written a lot about how the biggest obstacle between you and your financial goals is—you.
Knowing what to do with your money is the easy part.
Actually doing what you know you should do is where almost everyone gets tripped up.
The field of ‘behavioral finance’ is like a melding of traditional economics with psychology.
Economists can tell you the ‘rational thing’ to do with your money, and a psychologist or behavioral specialist can help you actually follow through. At least, that’s the idea.
Today, I am reviewing the results of a 2022 study, which looked at five different behavioral finance interventions and evaluated which moved the needle and which didn’t
The big question
The study seeks to determine the effeicvnes of different behavioral strategies in increasing retirement savings among U.S. Army personnel.
Between 2016-2018, the researchers implemented five different behavioral interventions—a fancy way to say a strategy to get people to save money/
The interventions evaluated included:
Information Emails: Sending emails that provided educational content about the benefits of saving and details about the design of the Army’s savings program.
Action Steps: Offering clear, actionable steps to encourage enrollment and increase contributions.
Target Contribution Rates: Suggesting specific contribution rates to guide participants toward optimal savings levels.
Active Choice Frameworks: Requiring individuals to make an explicit decision regarding their participation and contribution rates, thereby reducing procrastination.
Automatic Enrollment: Automatically enrolling service members into the TSP, with the option to opt out if they choose.
So, which of these five interventions had an impact on savings?
The more choice that was left in the hands of the saver, the less effective the intervention was. This tells us something we all intuitively know to be the truth: If you make it easy for people to stick their head in the sand and avoid their financial problems, they will do just that.
So, let’s review the impact each of these interventions had measured by the impact on participation (how many more people enrolled in the plan) and impact on contributions (how much more they actually save.)
#1—Information Emails
Impact on Participation: Increased participation rates by approximately 0.2%, a 6% effect size relative to the control group.
Impact on Contributions: Led to an average increase of $2.52 in cumulative contributions over six months.
I’m not going to lie, as someone who sends a weekly information email providing informational content about personal finance, I was hoping this would be higher!
#2—Action Steps
Impact on Participation: Increased participation by 0.5%, representing a 9% increase compared to the control group.
Impact on Contributions: Resulted in an average increase of $4.45 in cumulative contributions over six months.
Both points one and two are about educating people, which has a minimal impact (sadly.)
#3—Target Contribution Rates:
Impact on Participation: Boosted participation by approximately 0.7%, translating to a 13% effect size.
Impact on Contributions: Yielded an average increase of $5.73 in cumulative contributions over six months.
This takes things a step further, and when you actually put a target in front of someone, like suggesting they save 10% of their paycheck, it helps a little bit more, but it does not have a massive impact.
#4—Active Choice Frameworks:
Impact on Participation: Significantly increased participation rates by about 11%, equating to a 104% rise relative to the control group.
Impact on Contributions: Led to an average increase of $40.72 in cumulative contributions over six months.
Now we’re talking.
Making it mandatory to give a response to enroll in a retirement savings plan leads to a doubling of the number of people who choose to do so. Not allowing people to simply ignore the issue moves the needle in a big way.
#5—Automatic Enrollment:
Impact on Participation: Dramatically elevated participation rates by 37% , representing a 208% increase compared to the control group.
Impact on Contributions: This resulted in an average increase of $213.17 in cumulative contributions over six months.
Unsurprisingly, the biggest impact of all was when the choice was removed entirely. If you make enrolling in the retirement savings plan the automatic default option you are going to get a lot more people saving money.
Yes, some people will actively choose to drop out of the program, but most people just go with whatever the default option is.
Actionable Takeaways
For individuals and organizations aiming to enhance retirement savings, the study offers several practical insights:
For Employers:
Implement Active Choice Frameworks: Encouraging employees to make explicit decisions about their retirement contributions can significantly boost participation rates.
Consider Automatic Enrollment: For larger organizations, automatic enrollment can lead to substantial increases in both participation and savings, making it a worthwhile investment.
For Individuals:
Engage in Active Decision-Making: Take the initiative to assess your retirement savings options and make informed choices about contribution rates.
Seek Out Information: While less intensive, informational resources can still provide valuable guidance to help you optimize your retirement planning.
For Policymakers:
Promote Cost-Effective Interventions: Encouraging the adoption of active choice frameworks, especially in small to medium-sized organizations, can enhance retirement savings across diverse populations.
Final thought
So, does behavioral finance work?
Yes.
But they work best when they remove the ability for people to ignore the problem. This presents a major challenge for people who are not fortunate enough to have access to a retirement plan with automatic enrollment.
This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any significant financial decisions.