macauley on behavioural economics

I obliquely mention behavioural economics from time to time, for example when drawing from Nassim Nicholas Taleb’s Black Swan which is full of references drawn from BE to back up his own observations.

This is a summary of You can see a lot by just looking: Understanding Judgment in Financial Decision Making by  Ian MacAuley published by the Centre for Policy Development provided by Fiona Guthrie

Main points

The discipline known as behavioural economics has strengthened our knowledge of consumer decision-making. It explains why we make certain, consistent departures from what is generally described as “rational” decision-making. These departures result from our use of short-cuts (“heuristics”) in situations where more deliberation would result in more beneficial decisions, from short-sightedness, and from innate concerns for fairness in transactions.

Departures from rational decision-making – some examples:

Overconfidence: we have a tendency to overestimate our financial management and investing skills

Consideration of sunk costs: we find it very difficult to make decisions solely on the basis of future costs and benefits, particularly if it means implicitly admitting that we have made poor decisions in the past

The ‘disjunctive bias’: we display a poor grasp of statistics, underestimating the combined probability of disconnected events, which can, for example, leave us more exposed than we should be to events that would prevent us from meeting our financial obligations

Mortgage stress and myopia: we are likely to become over-committed in our borrowing because of short-sightedness, ‘hyperbolic discounting’ and a lack of understanding of the difference between real and nominal interest rates

Implications for financial institutions

Poor decision making, such as over-commitment on mortgages, is costly not only for consumers but also for financial institutions. Behavioural research reveals a strong bias to taking on more debt than would be prudent from a ‘rational’ perspective. This makes it all the more important that the suppliers of debt act responsibly and resist the temptation to exploit consumers’ biases to lead them towards decisions which they may later regret. In order to guard against this temptation lenders will need to shift away from performance pay based on simple sales volumes and reorient their business models towards long-term profitability rather than short-term growth or market share.

Policy implications

A deeper understanding of biases in our financial decision-making can inform more effective government policy. Financial literacy is necessary but not wholly sufficient for sound decision-making. The careful use of ‘default options’ can guide market decisions while still leaving room for individual choice. Behavioural research can point the way to simpler options for regulation (for example awareness of the costs of information overload can be used to shape shorter product disclosure statements). Awareness that people choose not to choose, or to choose from a constrained set of options in certain situations can alert governments that competition policy should be designed to improve outcomes for consumers rather than as an end in itself.