LISTEN: mp3 audio (06:57min)

According to Wikipedia, behavioral finance is a “separate branch of economic and financial analysis which applies scientific research on human and social, cognitive and emotional factors to better understand economic decisions by consumers, borrowers, investors, and how they affect market prices, returns, and the allocation of resources.” Among the things behavioral finance studies are the factors that influence people to make bad or short-sighted economic decisions. For example, why do many people opt for the unlikely chance of a big payout from gambling, and avoid the sure-fire success of regular saving?

As Jason Zweig notes in his July 18-19, 2009 “Intelligent Investor” column in the Wall Street Journal, “in 2007, the latest year numbers are available, Americans spent $92.3 billion on legalized gambling, according to Christiansen Capital Advisors; that same year, says the U.S. Bureau of Economic Analysis, Americans saved only $57.4 billion.”

Why do Americans put more dollars toward gambling than saving? Someone in the field of behavioral finance would theorize that people tend to over-estimate the odds of rare occurrences, like winning the lottery, or breaking the bank at Vegas, in part because the magnitude of reward is so enticing – “I know the odds are 10 million-to-one, but can you imagine what we could do with a million dollars!” Saving, on the other hand, provides minimal thrills, and no chance of outrageous gain. For many, potential thrills trump low-level guarantees. This is especially true with smaller amounts of money. Given the choice between saving $25 or buying 5 lottery tickets, the tendency to gamble is strong, because $25 saved doesn’t add up to much, but a single winning ticket could mean millions.

But what if there was a way to tie the thrill of gambling to the boring activity of saving? This was the idea behind the “Save to Win” program developed by Peter Tufano, a professor at the Harvard Business School.

In a campaign launched in February 2009, eight credit unions in Michigan offered one-year Certificates of Deposit, with a minimum deposit of only $25. These low-minimum, short-term CDs actually pay interest below those of conventional CDs, but come with a unique kicker: With each new CD, the depositor is entered in a monthly and annual drawing. The monthly winner receives $400, the annual winner $100,000. In essence, depositors get to play the lottery when they save money.

Zweig’s article noted the campaign has been quite successful: In 25 weeks, the credit unions attracted over $3 million in new deposits. But some of the best comments come from participants in the program, reporting their experience on the Internet. Here’s one, from “Dean L.” posted in a forum on www.savingadvice.com :

I had less than $5 in my bank account a couple of months ago. This had been a typical savings amount for me for as long as I can remember.

I have read about saving money and have known for a long time that it’s something that intellectually I know I should be doing, but there had never been the incentive for me to do so. The paltry interest rates that banks pay made me feel like it was a waste of time to put aside money, so I took my chances each month and played the lottery instead. It was always $2 here, $5 there, but it added up to close to $100 over the entire month.

That all changed two months ago when I walked into my local credit union and learned about a new savings promotion they were offering called “Save to Win” where if I placed $25 or more into a 1 year CD, I had a chance to win up to $400 on a monthly basis plus a chance at $100,000 at the end of the year. Although the payout isn’t as high as the lottery, it gives me a chance to win something which makes the low interest rates more palatable.

Since that time I have put aside the money that I would have put toward the lottery and instead have placed it into CDs. I’ve opened 5 CDs over the last 2 months which has my savings at more than $125 – an amount that I haven’t had saved in years. I plan to continue to place the money I would have spent on the lottery into CDs for the rest of the year and should have close to $1,000 in savings by then. And if I’m lucky, I may win some cash prizes along the way or $100,000 at the end of the year.

One of the popular books relating to behavioral finance is Nudge (Penguin, 2008) by Richard Thaler and Cass Sunstein. The subtitle of the book is “Improving Decisions About Health, Wealth and Happiness,” and extensive sections of the book are devoted to methods used by individuals and institutions to provide strong incentives for a desired financial outcome, whether it is cutting expenses, saving for retirement, or even spending money on luxuries.

In the paradigm of the book, the “Save to Win” program is an example of what the authors call “Libertarian Paternalism,” which means people are free to choose, but choices are structured to encourage the “better” choice. No one is forced to put money in a one-year CD, but as Dean L. writes, the “chance to win something…makes the low interest rates palatable.”

The next time you have a discussion about your long-term financial objectives (with your spouse or one of your advisors) you might want to consider “nudges” you could include in your financial strategies. You might not be entered into a $100,000 drawing, but any strategy that can help you “save to win” is probably a good one.