Friday, January 26, 2007

Props to Behavioral Finance from Chairman Bernanke

I made a point of tuning in to watch the testimony of Fed Chairman, Ben Bernanke to the Senate Budget Committee on January 18. Why? Because I love watching senators who pretend to have a working knowledge of macro-economics attempt to ask "tough" questions of a man who clearly knows 500 times more about the subject. It reminds me of the conversations with my mechanic when I used to bring my old car in:

Me: So, what did you find out?

Mechanic: Looks like the needle valves in the carburetor got gummed up and its making a lean oxygen ratio in the float chamber. We'll have to change the plugs and patch the intake manifold. It'll take a couple days.

Me: Ah. I was afraid it might be the old Carbonator acting up.

Mechanic: Carburetor.

Me: Yeah, the Carburetor. That's.. uh, that's what I said.

To me it's the best part of the proceedings. But I experienced an unexpected delight when Mr. Bernanke single out the field of behavioral finance as being one of the most promising ways to address the long-term savings crisis.

He was asked what positive changes could be made in policy to help people's savings rates. He said that the most exciting options are coming from the psychological side of investing research. He referred specifically to the new "opt out" approach being taken by companies regarding their 401-K plans.

Tax free savings plans are a great idea, but they have always been optional. It used to be that employees were asked, "Do you want to take money out of your pay check to and put in the 401-K savings plan." A lower paycheck!?! Too many people said no.

But when the option was reframed to, "You're currently in our 401-K savings plan, would you like to opt out?" Again, most people said no.

The reason? Doing something requires an effort. Doing nothing does not. Physicists call this inertia. Behavioral Finance Consultants (such as Dr. Peterson and myself) call it The Status Quo Bias. The fact is, without a compelling reason we'd rather not generate the emotional energy necessary to make a change. The effect is so strong that most people who inherit a position will most likely make no change even when they admit that they never would have chosen that position for themselves!

Something as simple as applying the Status Quo Bias for savings plans does wonders for increasing the savings rates of employees. It was nice to see Chairman Bernanke credit the behavioral finance committee for its simple, yet revolutionary contribution.


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