When taking financial decisions, people often make suboptimal choices, due to behavioural traits and cognitive biases. For example, consumers’ limited attention prevents them from comparing alternative goods, services, and financial products thoroughly, which increases expenses on loan payments. Present bias, making individuals opt for a smaller remuneration immediately rather than a larger one in the future, is positively associated with household debt and debt arrears. Mental accounting, when a person divides his/her income by its source (a salary, a bonus, or a cashback), leads to suboptimal allocation of resources (link in Russian).
Such cognitive biases and related suboptimal decisions may become more pronounced, due to individual characteristics. For example, poverty and financial stress increase the likelihood of myopic decisions, enhance impatience, and reduce cognitive abilities. Lower cognitive abilities, in turn, are usually associated with higher impatience and risk aversion as well as with more frequent errors in probability assessment. This means that the market may simultaneously include consumers who are more prone to errors and those who are relatively free from these anomalies.
The existence of behavioural anomalies creates opportunities for sellers to exploit them for profit, for example, by using automatic subscriptions, offering complicated fee structures, making paid services less conspicuous, etc. The more consumer information sellers collect, the easier they can discriminate based on behavioural characteristics.
All this creates two-way effects. First, the exploitation of consumer behavioural biases causes additional welfare losses for the most socially vulnerable groups. A decrease in welfare, in its turn, may increase stress provoking new errors and illiterate financial decisions, thus causing further welfare losses.
However, behavioural economics may help mitigate the effect of cognitive biases on financial decision-making. We have conducted an overview of the relevant methods, which was published in the new issue of the Russian Journal of Money and Finance. It demonstrates how behavioural economics can help directly impact decision-making in finance and change the decision-making environment.
Affecting human behaviour
The effect of cognitive biases can be mitigated through influencing people’s behaviour by teaching them financial literacy, developing financial culture, enhancing attentiveness, and providing tools to combat cognitive biases.
Increasing financial literacy. Studies confirm a correlation between financial literacy and financially literate behaviour. For example, field experiments in Chile demonstrate that people with higher financial literacy scores choose more profitable pension accounts and are less dependent on the peer effect – the behavior of their social environment. In Peru, the financial literacy programme taking into account the principles of behavioural economics had increased the level of the trainees’ knowledge by 30% by the time it was completed and improved their ability to manage financial resources by 18%. Individuals with higher financial literacy scores demonstrate a higher propensity to save and are less vulnerable to financial shocks. Financial literacy is positively related to participation in financial markets and negatively related to the use of informal sources of borrowing, as shown by the study based on evidence from Russia.
Shaping financial attitudes. Financial knowledge does not always (link in Russian) translate into financially literate behaviour. A study conducted in India shows that the acquisition of numeracy skills (for instance, calculating compound interest) does not lead to financially literate decisions. However, changing learners’ financial attitudes (by reinforcing a positive outlook on various financial instruments) made them more likely to open savings accounts.
Therefore, better financial literacy is not only achieved through providing knowledge, but also by shaping financial attitudes (as in the case with India) and teaching simplified rules that are called ‘ rules of thumb’ (for example, ‘always save at least 10% of your income’).
Keeping it simple. Since human attention is limited, the presentation of information is critical. A simple, visually clear, and attractive presentation, as well as emotional feedback from the learners can enhance the efficiency of financial literacy programmes. Simplicity and visual clarity can be achieved through the use of a simpler language, infographics, and a well-structured layout, while simulators and gamification principles contribute to attractiveness. Сompared with texts, videos are more attractive (link in Russian) to consumers and easier trigger people’s emotions, i.e. better engage the audience.
At the right time and in the right place. The effect of financial literacy programmes on financial behaviour fades over time. A study shows that 10 months after the training, the effect of an 18-hour programme is commensurate with that of a recent six-hour one, while the effect of the latest one-hour programme is commensurate with that of a 12-hour programme conducted 10 months ago. Therefore, short training programmes provided to individuals exactly when they need the relevant knowledge and can immediately apply them will probably be more useful for people. This might include training borrowers who have already faced the problem of default on their debts or training migrants when they need to choose a channel for sending money to their home country. Timely provision of educational programmes is especially important for vulnerable groups.
Developing financial culture. Since financial literacy does not always result in responsible financial behaviour, enhancing financial literacy should be coupled with developing financial culture (link in Russian), i.e. values and attitudes supporting financially literate behaviour, in particular, a long-term planning horizon and responsibility. Furthermore, sociocultural features should be taken into account. Data from the Global Preferences Survey show (link in Russian) that Russian consumers are more impatient (prefer smaller benefits today to larger benefits in the future) than those from most European countries. This may create additional challenges in financial behaviour, such as excessive consumption or difficulties with timely loan repayment and insufficient savings for the future.
Providing tools to combat cognitive biases. Providing information about cognitive biases and teaching ways to combat them is of great importance for improving financial literacy. The realisation of cognitive biases may help mitigate their effect when making financial decisions. For example, as regards savings, promising tools to combat cognitive biases include:
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targeted savings with goal visualisation capabilities, which lead a person strive to achieve a goal they have already visualised in their mind, due to the loss aversion effect;
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voluntary restrictions pre-established by an individual, which help limit spending at the moment of temptation and mitigate the problem of present bias and a lack of self-control;
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automatic deductions which help overcome procrastination and present bias when it is necessary to transfer money to a savings account;
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‘taxes’ on expenses that an individual sets for him/herself to make sure that a certain percentage of each purchase is transferred to a special savings account;
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reminder messages to which a person can subscribe to combat inattentiveness.
Promising tools in the area of consumption allow users to conveniently structure and control their income and expenses, establish spending limits, set financial goals, and make public promises to achieve them. As for lending, promising tools allow people to set up automatic loan repayments and subscribe to automatic deductions. Each tool can be improved based on insight from behavioural and experimental economics. In particular, a study in Kenya reveals that reminders of loan repayments sent in the evening are 8% more efficient than those sent in the morning.
Changing the decision-making environment
Behavioural economics can be used to promote financially literate behaviour by changing the environment in which an individual makes decisions, for example, through nudging towards preferable behaviour, regulation, and modifying the information environment.
Nudging and choice architecture. While standard regulation associated with bans, taxes, and subsidies is usually considered an example of ‘hard’ paternalism, the nudge theory, developed by Richard Thaler, one of the founders of behavioural economics, and lawyer Cass Sunstein, is usually associated with ‘soft’ (libertarian) paternalism. The latter involves that people will retain freedom of choice but the choice will be structured to nudge them towards financially literate behaviour. For example, a joint study by Thaler and his co-author from the University of California shows that automatic enrolment plans for employees, whereby they remain free to exit the savings programme and change the savings rate, result in a notable increase in savings, as the average savings rates of the programme participants went up from 3.5% to 13.6% over 40 months.
A meta-study (over 200 studies) by psychologists from the University of Geneva who analysed nine types of such tools shows that these default options have the strongest effect as compared with different nudging tools. A field experiment conducted in Afghanistan by economists from the University of California and the University of Washington reveals that the effect of the default option on stimulating people to save is equivalent to introducing a 50% bonus to the savings amount. The experiment involved 949 employees of the country’s largest mobile operator. They were randomly assigned to have either 5% or 0% of their salary automatically directed to the savings account. Separately, each employee was randomly paid a 25%, 50%, or 0% incentive from the employer in addition to the savings amount. The default option had a long-term effect: after the six-month experiment had been completed, the participants were asked if they wished to continue transferring part of their salary to the savings account. Almost half (45%) of the employees agreed to continue to make savings. Furthermore, the rate of participation in the savings programme was 25% higher among those who had part of their salary transferred to the savings account by default at the beginning of the experiment.
Regulation. Several countries (such as Australia, Canada, the USA, the UK, and members of the European Union) apply regulation aimed at limiting the exploitation of behavioural biases by businesses. Based on the analysis of international experience, at least three key areas of regulation can be identified: regulation of consumer information requirements, regulation of the online purchasing process, and regulation of pricing practices.
Consumers’ ability to make optimal economic decisions deteriorates notably when they deal with complicated, heterogeneous, and vague information. Therefore, the regulation of consumer information requirements is associated with simplifying access to significant data, facilitating the comparison of characteristics of similar goods and services, and enhancing information transparency. For example, a team of behavioural economists in New Zealand has formulated six principles of financial product disclosures, which should be: 1) short and simple; 2) standardised; 3) clear about the risks and benefits of the product; 4) meaningful to the consumer; 5) well presented (with charts and other visual representations); 6) the approach to disclosures should be tested before the implementation. Following these principles helps, on the one hand, reduce cognitive biases (resulting from information overload and inattention), and on the other hand, make sure that the changes proposed are effective before they are widely implemented.
Field experiments confirm the significance of information transparency for financial services consumers. For instance, a study involving 300,000 people from the UK shows that adding information on last year’s premium to the home insurance policy extension notices has caused 11% to 18% consumers to negotiate their policy or to switch to another insurance company. An experiment held in the USA shows that borrowers informed about accumulated payday loan expenses were 11% less likely to take out such loans in the next four months than the control group that received no information.
Easy and quick online purchases make consumers particularly susceptible (link in Russian) to cognitive biases in the digital environment. To protect consumers, a cooling-off period may be set in the event of online purchases of financial products, for instance. Thus, in the European Union, financial consumers have the right to withdraw from a contract within 14 days without penalties and without giving any reason. Also, the European Union adopted a directive banning pre-ticked boxes for charging additional payments when shopping online and establishing the right of consumers to the reimbursement of such payments.
One more area of behavioural regulation is associated with restricting the pricing practices exploiting consumers’ behavioural biases, such as drip pricing. In the event of drip pricing, the buyer sees only a part of the product’s price up front and, as he/she proceeds through the buying process, additional fees and services are added to the initial price, resulting in the final price that significantly exceeds the initial one. This type of pricing complicates the comparison of similar goods and services because it requires significant time and cognitive resources. Furthermore, a buyer may become subject to the endowment effect (link in Russian), when he/she has a sense of ownership of the goods that have already been chosen and added to the trolley, but have not been paid for yet. This effect makes it difficult for an individual to forego what he/she has ‘acquired’ in favour of a better option (which is yet to be found). The results of the study held in the UK suggest that drip pricing is the most harmful type of price framing in terms of welfare loss to consumers.
Limitations and risks
Despite the significant potential of behavioural economics to promote financially literate behaviour, there are several limitations and risks associated with this approach.
Ethical risks. The ethics of nudging have been increasingly discussed in recent years. First, there is always a risk that manipulation in someone’s interests will be disguised as nudging towards the right behaviour. Second, nudging gives rise to a risk associated with increasing paternalistic sentiment reducing the sense of responsibility for the choices made. This will trigger a chain of negative economic effects. Third, cognitive biases of the regulator itself may also entail negative consequences.
Heterogeneity of effects. Behavioural biases are largely related to individual characteristics, such as cognitive abilities (link in Russian) or individual experience (link in Russian). This complicates the development of universal solutions to the problem of behavioural anomalies that are equally effective for groups with different characteristics. This means that behavioural tools for different population groups should be explored in detail, and potential negative effects for groups that are not the immediate target should be considered.
Importance of testing behavioural interventions prior to their implementation. Despite the significant experience of experimental research in various areas and countries, it should be noted that behavioural interventions that proved effective in one country do not necessarily work in another. Publication bias is another reason to be careful when referring to the results of the experiments described in the studies. Academic journals are more likely to publish studies with large and statistically significant effects, which can inflate expectations regarding the effectiveness of behavioural interventions.
Underestimation of fundamental problems. Finally, a focus on the possibilities of applying behavioural economics should not replace the addressing of more fundamental problems, such as low income levels, imperfections in the institutional and regulatory environment, etc. The use of behavioural tools should complement, not replace, solving these problems.
