The Nudge Theory is a behavioral finance theory that helps investors to improve their savings and take the road to better financial wealth, and is also known as “The Gentle Push”. This theory states that minor changes in context can encourage people to naturally make the best decision in their own self-interest.
Read on to find out more!
Improve Your Savings Through the Nudge Theory
As you surely know, “nudge” stands for goad, little push … but what does a gentle nudge have to do with savings and investments?
The American professor of Behavioral Economics and Cass Sunstein in their book “Nudge” have always been convinced that the use of levers on a psychological level can positively influence our propensity to save.
The most fitting example is the automatic enrollment in individual pension plans, implemented in the last decade in the United States. This program is called SMarT, from the acronym Save More Tomorrow.
The automatic employee enrollment program for retirement plans has produced excellent results since it was adopted. According to recent statistics, in the United States today, 58% of pension plans automatically register workers. In 2000, the same was only 8.1%.
In fact, when it comes to retirement, individuals are more likely to postpone their savings into the future. This is a situation that afflicts also millions of Italian savers, who will suffer all the negative effects when they enter retirement age.
We Are Driven by Emotions
If you are a regular reader of my blog (you are always on time to become one from now!) you will already know that I often emphasize how we human beings tend to perform actions driven by emotions, and only in a second moment, our rational superior courtship leads us to justify what we have done with logic.
This thing is even more valid when we are dealing with money because all our subconscious beliefs come into play and lead us to make decisions that are often terrible for our finances.
Thaler then theorized that if we can be aware of our irrationality, we can also master it and exploit it to our advantage, creating what is called the “architecture of choice”.
If we create a path made of gentle pushes, without anything being forbidden to us, we will be better able to carry out the best actions in our interest: for example, if we want to stay on a diet, having fresh fruit and healthy snacks under our eyes and on hand is much better than forbidding us to eat junk food.
The Loss Aversion Bias
If you know the compound interest theory, defined by Albert Einstein as the eighth wonder of the world, you will know that small amounts accumulated over time generate a large sum in the long term thanks to the sum of their own interests.
This means that a 20-year-old who starts depositing a hundred dollars a month into a fund could find himself a millionaire at retirement age.
If you want to play with compound interest you can do your calculations here, using the interests of the main investment funds you know (always DYOR!)
Here I am not evaluating the usefulness or otherwise of finding yourself millionaires at over 60, I am just telling you that it is possible to do so.
First, many don’t know compound interest exists and how to use it. But even those who know, run up against a powerful cognitive bias* of ours, called loss aversion.
Loss aversion is a tendency in behavioral finance where investors are so fearful of losses that they focus on trying to avoid a loss more so than on making gains.
When it comes to improving savings, most people only see the money they have to put away and cannot spend (the loss) rather than the future reward for constantly saving (the gains).
Furthermore, regular savings require iron discipline, which very few have.
This is why most people have little money!
*a bias in psychology is a kind of cognitive distortion, an erroneous prejudice that makes us make bad choices.
How to Save by Following the Teachings of Nudge Theory?
Of course, if you are reading this post you want to stand out from the crowd and know how to overcome our innate irrationality and loss aversion bias to improve your savings.
One of the ways to start putting into practice the precious teachings of Nudge Theory is to adopt mechanisms that allow you to automatically put aside your savings. In fact, it has been proven that the possibility of making automatic payments turns off our emotional and irrational part, allowing us to save every month without even realizing it!
With Apps like Gimme5, it is possible to set automatic savings recurrences from your profile, thanks to which you can set aside a share of savings over time that you never expected.
In addition, once you deposit you can get badges that make your experience more fun and challenging and allow you to unlock new features.
I’m talking about Gimme5 because I use it myself and you can deposit from $5, but there are dozens of others to choose from, it’s up to you to decide which one best suits your needs.
In Short Words
If you want to improve your savings, you must take into account the functioning of our mind, as Richard Thaler did with his Nudge theory, and become aware of our being irrational and averse to losses.
Using savings management apps can prove to be the right move to make to save money without even realizing it!
Are you already a champion in money management or do you need to improve? Write your ideas in the comments and let’s talk about them together!