Use Irrationality Against Yourself!

Behavioral finance and economics have recently exploded onto the national scene. These two behavioral topics deal with the idea of ‘rationality’; they are concerned with the rationality of the decisions of members of a population and the limits to an individual’s rationality. Studies show that humans have many irrational tendencies which can be shown experimentally.

Authors such as Dan Ariely (Predictably Irrational: The Hidden Forces that Shape Our Decisions Use Irrationality Against Yourself! ) detail the irrationality of common people in their books. Covering factors such as price anchoring, emotional effects, and risk mispricing, these books have had considerable sway (Sway: The Irresistible Pull of Irrational Behavior, Ori and Rom Brafman) over some of the policies of the last few years and policies currently being debated. Specifically, economists (and by extension, politicians) have clued in on ways to nudge (Nudge: Improving Decisions About Health, Wealth, and Happiness, Richard H. Thaler Use Irrationality Against Yourself! ) individual behavior using knowledge of irrational behavior to shape decisions.

Big Brother and Your 401(k)

One of the big wins for behavioral economists in the recent past was the Pension Protection Act of 2006. Auto-enrollment in workplace retirement plans overcomes the desire of some employees to not do the extra work enrolling requires. Plans also now have the ability to place individuals in funds other than cash equivalents (such as target date funds). Overcoming employee lethargy was the key motivation of these two features of the law. Of course, employees still have the ability to opt out of plans or change their investment, but employees who wouldn’t have taken the time to set up a 401(k) before may end up staying in the plan. Results are mixed; participation is slightly up but only time will tell if participation will continue to climb as more companies adopt these strategies.

Onto Your Life…

Another bias humans have is the tendency to overrate short term rewards when comparing them to long term rewards. This shows up in the irrational behavior of people spending money at the expense of long term savings. What if we could override this irrational behavior by using another one of our biases against ourselves?

Gamble on Yourself! From matze_ott

Enter the savings lottery! (Rhetorical question alert!) Why do people enter the lottery? With few exceptions, it is impossible to have a positive expected value when it comes to a lottery. Still, people enter the lottery hoping to pull off what amounts to a miracle. “You can’t win if you don’t play.” Indeed. I guess it’s also fun?

Enter Jason Zweig’s article, “Using Lottery Effect to Make People Save“. A number of Michigan Credit Unions have taken this exact argument to produce a Certificate of Deposit product called “Save to Win.” This interesting product pays an annual percentage yield of 1.0% – 1.5% but enters investors into monthly lotteries for up to $400 and an annual lottery of $100,000. Even though the product pays a smaller rate than the national average, it has attracted $3.1 million in 25 weeks. Check out the web site.

What Does this Cost the Credit Union?

Let’s pretend these credit unions get all of their money up front to make this math easy. I’m about to make a lot of assumptions, so yell at me in the comments.

$415 is the liability for an average month ($100 x2 + $50 x3 + $25 x2 + $15 x1). 4 other months have an additional $415 ($400 x1 + $15 x1) liability. This works out to $6,640 in liabilities per year. Additionally, each credit union has to pay $12,500 towards the yearly $100,000 grand prize. This works out to $19,140 in order to attract this money.

$3.1 million / 25 weeks / 8 credit unions * 52 weeks = $806,000 in deposits per bank, per year. Taking Central Maccomb Community CU as an example, 1.5% is the APY on their CD. BankRate lists the national average CD APY (7/22/09) as 1.890%. 1.890% of $806,000 is $15,233.40. 1.5% of $806,000 is $12,090.00. It seems Maccomb could have been a little cheaper on the yield (or maybe Credit Unions are that much better than banks?).

I think this is a great idea… an example of the market using human bias to produce a positive effect. Enough of what I think though; what do you think? Is this ethical? Is it a good idea?

Vegas thubnail sourced from www.flickr.com/photos/66727626@N00/377859315, shot by James Phelps.

Posted by PK on July - 23 - 2009

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http://dqydj.net CameronDaniels

A couple notes:

a.) When talking about the lottery (or underrating future returns for short term rewards), saying that the long-term is underrated is a very personal, normative claim. Some people may just be more conditioned to appreciate the present or the tomorrow. This does not imply any faulty reasoning on anyone’s part, just a difference in preference.

b.) For Economics purposes, rationality only applies to three things (a, b and c are different items or goods)(~ means indifferent, < or > mean less preferred than and more preferred to, respectively):
i.) A~A
ii.) A>B, A iii.) if A>B and B>C, then A>C

Only those three things need to be satisfied by every consumer for ‘rationality’ to be legitimate, which makes most of Ariely’s wideswept social critiques not necessarily applicable to modern economics.
http://dqydj.net PKamp3

I’ll respond to those in turn:

1) On a ‘strictly math’ basis, playing the lottery is an irrational decision (the rational decision is saving the money for a more pressing concern). I guess I should note that all of the personal factors like enjoyment and peer pressure also make a difference. So yes, personally, I think playing the lottery isn’t the best idea.

2) I’m more concerned with irrationality on an individual basis… how does someone stop themselves from smoking? How do you stop yourself from eating that third doughnut? These kind of choices may bother someone consciously. I understand that on a macroeconomic scale any individual behavioral differences most likely balance out. However, if someone like the lady in the article wanted to start saving but can’t (and she *wants* to save), not only is locking money in a Certificate of Deposit a good idea (akin to locking a fridge when dieting) but using her love of the lottery to make a positive impact on tomorrow’s bottom line is also good thinking.
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http://www.linkedin.com/pub/dir/Anne/Lay/ Darryl Souchet

Excellent post. Hope to see many more similar articles in the future.