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Small Steps That Help You Make Good Decisions—Financial and Otherwise

Read this Q&A with Richard H. Thaler and Cass R. Sunstein, authors of <i>Nudge: Improving Decisions About Health, Wealth, and Happiness</i>.

Accepting that fifth credit card and spending to its limit? Made sense at the time.

Buying a boat by refinancing your home with an adjustable-rate mortgage? Why not—everybody did.

So many people make bad decisions. In their new book, Nudge: Improving Decisions About Health, Wealth, and Happiness, authors Richard H. Thaler and Cass R. Sunstein explain factors that influence decision making—subconscious biases, confusing wording, simple human fallibility—and how they can lead to devastating consequences. The current economic crisis comes to mind.

“The false assumption is that almost all people, almost all of the time, make choices that are in their best interest or at the very least are better than the choices that would be made by someone else,” write Thaler and Sunstein. In fact, “real people have trouble with long division if they don’t have a calculator, sometimes forget their spouse’s birthday, and have a hangover on New Year’s Day.”

The authors mine research from behavioral science, economics and law to formulate what can be done to help people choose better—while still allowing them to choose (however poorly) as they see fit. By implementing a few simple new ideas, people can be nudged toward better retirement planning and health care choices.

Thaler, a world-renowned economist at the University of Chicago, and Sunstein, a Harvard law professor, spoke with AARP Bulletin Today about how people make decisions and why we could all use a good nudge now and then.

What do you mean by “nudge”?

CRS: A nudge is any change in the context of a decision that preserves freedom of choice but makes people’s lives go better. For example, automatic bill payment—that’s a little nudge that makes life easier and that might save you money by eliminating those pesky late fees.

When can people use a nudge?

RHT: Anytime that, for whatever reason, they tend to make mistakes. So if you’re absent-minded, you make lists and set alarms. Those are nudges.

CRS: Good nudges are always welcome.

What’s one of the best nudges you know about?

RHT: My favorite example is where authorities etched the image of a housefly in the urinals in the Amsterdam airport. Men instinctively aimed at the fly, and spillage was reduced by 80 percent. That housefly was a nudge—nobody was telling the men that they had to aim better, but they did.

CRS: Another example is when some electric companies informed customers that their neighbors were using far less energy. As a result the higher-consuming customers often reduced their consumption. The companies also printed a smiley face on bills sent to customers using less than average, and a sad face to those using more.

Once people are informed, they tend to do better, both economically and for the environment. It’s also true that if people learn that their energy use is lower than the average, there’s a risk they’ll actually increase their energy use. But that unfortunate effect was prevented if people were given a sign of social approval, such as the smiley face. That’s a good example of how social norms have a big influence on people

It seems that governments and institutions are in a position to nudge. What about regular people?

CRS: Sure. One way is the “snudge,” where people self-nudge. You can self-nudge by, for example, keeping healthy food in the refrigerator, rather than lots of brownies and chocolate cake. You can join a health club that is fairly expensive as a way of making a commitment to going regularly. If you make a bargain with friends, asking them to make sure that you stick to your diet or stick to your financial plan, that’s a self-nudge.

Why do people make so many bad decisions?

RHT: Part of the problem is that the world has gotten a lot more complicated. Mortgages are a good example. Thirty years ago, most mortgages were of the 30-year, fixed-rate variety, and choosing the best mortgage was very easy—just look for the lowest interest rate. Now, mortgages have variable rates and teaser rates and balloon payments and fees and all sorts of things, so choosing the best option has become very complicated. It’s just hard! People are very busy, and they’re faced with complicated decisions. It’s not surprising that they may not make the right one.

Many of the nudges in your book focus on financial stability. Did any bad nudges contribute to the current economic crisis?

CRS: One problem is that humans are very attuned to what other people do, so there’s a risk of herd behavior, especially when things are complicated. In the real estate context, a lot of people were told that the price of real estate constantly goes up and that it’s the best, safest investment. It was repeated so often that people believed it. Between 1997 and 2004 we had a speculative bubble, and people kept investing because they thought other people were investing, driving prices unrealistically high. The bubble was bound to pop. Because of the herd behavior we had many people making decisions that weren’t so sensible.

Another problem is that there used to be a social norm in the United States to pay off your mortgage as soon as you could. Because of the recent refinancing craze, a lot of people didn’t pay off their mortgage. Instead they refinanced and had a nice vacation or bought a new car. That’s a recipe for trouble.

What kind of nudge might help the U.S. economy?

CRS: One possible reform is to ensure better transparency between borrower and lender. We don’t have a very sensible system of disclosure right now. We have a 1970s disclosure requirement system in a 21st-century world. That means the lender’s disclosure requirements fill up pages and pages of fine print, which don’t really give the borrower a sense of the risk they face. We nudgers favor what we call simplified transparency, which means that lenders would have to periodically disclose to people what really matters, which is the whole package—the risk, the interest rate, the fees, everything.

RHT: We argue that lenders should also be required to give people a machine-readable electronic version of that disclosure. With one click, borrowers would upload the file to a website that would help translate the terms. If this had been available, many of the people who took out mortgages that they couldn’t really afford would have been able to figure that out. All in all this kind of electronic disclosure can be one of the steps we take to prevent the next crisis. There’s no doubt that if they choose, firms can help consumers become more responsible financially.

In the book, you talk about “choice architecture.” What is that?

CRS: Any building has an architecture, meaning there are bathrooms in a certain place, offices are aligned a certain way, and these architectural decisions will have consequences for how much private space people have, how much social interaction there is, what people’s daily experiences are like.

Choices have an architecture, too. Sometimes we don’t pay attention to that because we take the architecture for granted, but it’s nonetheless there. For example, the process of renting a car has choice architecture. There’s a set of options and a default package for paying for certain things such as insurance or gas, and you’ll get those elements unless you modify the package. There’s also phrasing that might encourage you to add certain things or not delete others.

Those are all part of choice architecture. Sometimes the choice architecture can be helpful, sometimes confusing, sometimes self-serving for the companies, sometimes very much in the consumer’s interest. We’re often not very aware of the choice architecture, but the influence is nonetheless there.

Give an example of choice architecture that failed.

RHT: President Bush’s prescription drug coverage plan, Medicare Part D, is the best example. On one hand, the program definitely lowered the price of drugs for seniors. On the other hand, I would nominate it as the worst bit of government choice architecture in history.

The reason it failed is because the most important thing to the designers of Part D was maximizing patients’ choices—which is fine, but then they gave essentially no help to people in finding the best choice. For example, the government offers a website to help people choose among the 50 or more plans in their state. But to use that website, you have to type in the name of every drug you take and the correct dosage. There’s no spell checker on the site, and since drug names are often like strings of random letters, it’s very easy to make mistakes. So you’re left with no help at all.

Also, for the group of so-called dual-eligibles—the people who were eligible for both Medicare and Medicaid—the government was forced to choose a default. Rather than pick a default that was good for each person, the government instead picked one at random—they literally picked one out of a hat! On the other hand, the state of Maine has developed a program that makes an educated guess as to which of the programs would be best for people, which saves taxpayers and participants money. But the federal government has discouraged that on the grounds that they don’t want government to interfere too much, and I think that’s disgraceful.

Is it important to have a default option—a choice that’s made for you unless you choose otherwise?

CRS: Default options often stick because people are reluctant to change them. Automatic enrollment in a savings plan is so effective because it changes the default from nonenrollment to enrollment. People who are busy will usually just say, “yeah, whatever,” to the default. So, “yeah, whatever” is a common reaction to choices, especially when things are difficult and complicated.

One reason we stick to the default is that it provides information about what sensible people—the choice architects—think is best for us or about what other people do. If the default rule is that you get insurance for a certain set of harms, people tend to think, “Maybe someone who knows something about health and insurance and such thinks this is a good condition to get insurance for, so I won’t waive that.”

Another reason the default will stick is simply because inertia is a very powerful human force. People frequently do what is suggested, then move on and think about other things.

Can simply being aware of the concepts you talk about in your book help people make better decisions?

CRS: I hope so! If we were all machines, we’d make the right decisions all the time, without bias or without any regard to choice architecture. If people are aware of their susceptibility to disregard the long term, or their vulnerability to unrealistic optimism, that sometimes can be a safeguard against making bad choices.

Krista Walton is an assistant editor of Preservation magazine.