This blog explains the importance of insights gained from the field of behavioural economics in advancing economic development. Using a case study of financial decision making, the blog highlights the behavioural biases that individuals are faced with when making financial decisions. To ensure suitable financial decisions for the improved economic well-being of citizens, policy makers can incorporate behavioural insights as a complement to financial education programmes and financial literacy initiatives for optimal societal outcomes.
Behavioural economics
Behavioural economics advances the notion that people sometimes make irrational decisions or choices purely influenced by psychosocial factors. People are essentially influenced by their emotions, their environment, and circumstances. Principles and insight from behavioural economics can benefit both the private and public sector and influence the development of policy and strategic frameworks that influence people to make beneficial decisions.
Policy makers around the world consider behavioural insights an important component of policy design, with the aim of incorporating human behaviour in policy making to improve individual economic decision making and to enhance welfare and development. Since people are faced with choices, a consideration of behavioural insights in decision making can help understand why an individual prefers one choice over another, what informed the decision and how it impacts how people behave.
Impact of behavioural insights on financial decision making
Every policy relies on explicit or implicit assumptions about how people make choices [1]. The World Bank explains that behaviourally informed policy pays special attention to the social, psychological, and economic factors that affect people’s decision making and actions [2]. An understanding that humans are affected by behavioural biases and that these are subject to change overtime is crucial for policy design [3].
In individual and household decision making, savings play a crucial role in mitigating the impact of financial difficulties. Savings as a component of household decision making aids in reducing the risk associated with having inadequate resources in future [4]. People save for several reasons including to cover future expenses, for investment in education or a business venture, for old age needs, or for emergencies [5]. Globally, approximately 76% of adults in developed economies have savings, while 42% of adults in developing economies have savings [5]. This shows that developing economies still have a poor saving culture, and those who save use informal products or less risky products. This hampers wealth creation and perpetuates poverty. This is because savings are crucial during financial difficulties and contribute to increased investment levels in the broader economy thus, stimulating economic growth.
In addition to savings, long term investments, including stocks, bonds, and real estate, inter alia are equally important for building wealth and sustaining economic prosperity. However, people generally do not engage in these types of investments due to the perceived risk associated with them. This, in some cases, may be due largely to behavioural biases that exist regarding these investment portfolios, conditioning how, when and where people save or invest.
Behavioural biases
Oftentimes, financial decisions on savings and investments fall prey to behavioural biases which can be cognitive or emotional biases. These biases compel people to take financial decisions that make them better-off or worse off. Emotional and cognitive biases that may hinder optimal financial decisions are listed below.
Emotional biases
Loss-aversion bias: This occurs when individuals tend to strongly prefer to avoid losses as opposed to achieving gains. In financial decision making, loss aversion can result in individuals holding on to loss making securities and savings that have little or no chance of appreciating again.
Endowment bias: This is an emotional bias where an individual places more value on an investment portfolio that they currently have than what they don’t have. This bias may be triggered by an emotional attachment to a savings account or investment portfolio and thus results in the individual saving or remaining invested in a certain portfolio when a more aggressive asset may be more appropriate and may have better prospects for growth.
Status quo bias: This arises where individuals are comfortable in keeping things the same and are reluctant to change. In financial decision making, this can include a refusal to change a savings option or investment portfolio. In the absence of significant challenges, the status quo is maintained. Such people rely on default choices, which do not change despite available alternatives with better benefits. Consequently, this results in holding portfolios with risk characteristics that are inappropriate for a circumstance. Market conditions change, a willingness to adapt and change savings or investment strategies can be positive.
Overconfidence bias: This is a bias in which people demonstrate unwarranted faith in their own intuitive reasoning, judgment, and/or cognitive abilities owing to past successes. This overconfidence may be the result of overestimating knowledge levels, abilities, and access to information. In financial decision making, this can lead to higher-than-appropriate risky bets being taken either in size or in the investment choice made.
Cognitive biases
Confirmation bias: This is a bias in which individuals process information by interpreting information in a way that gives more weight to those beliefs and opinions that align with their opinion. For example, individuals will tend to look for reasons to back up their investment choice as opposed to finding facts that might not support the idea. This may make an investment idea look better than it is.
Risk-aversion bias: This is a bias where an individual may prefer to go with an investment that has the lowest risk even though it may not bring in the most return. An individual may place more weight on a bad option as opposed to a good option, meaning individuals may miss out on good investments because they believe conditions will remain poor or will deteriorate over time. This results in individuals turning to risk-averse securities or savings accounts with low-risk profiles especially during times of volatility.
Herding: This is the tendency of individuals to follow a trend, as opposed to doing their own research.
Recommendations on the use of behavioural economics tools to overcome biases in financial policy making.
Certain interventions can be considered by policy makers in addressing biases by incorporating behavorial insights in policy development. These interventions can influence behaviour and optimize financial decision making:
Incentives: Incentives are a way to overcome emotional biases, especially the status-quo bias, where individuals rely on default choices and are hesitant to explore other available alternatives with better benefits. For policy making directed at encouraging a savings or investment culture, incentives that address such behaviour can be applied. This can be done by creating expectations of rewards such as prizes, to encourage people to save or to take up riskier investment portfolios. Monetary incentives such as payment for attendance and contribution matching have successfully increased uptake of financial literacy programmes and retirement savings accounts [3]. The figure below shows that policy making should incorporate behaviourial insights by considering the information individuals require and how this aligns with their incentives for optimal decision-making.
Source: Al-Zahrani, A. (2018). A journey in behavioural economics: from research to policies
Education and awareness: Education and awareness is key to overcoming both emotional and cognitive biases. Through communication, an individual’s knowledge or understanding of the need to take certain financial steps may encourage an increase in optimal financial decisions in the face of sufficient information. Also, through financial education and / or personalized financial training, a financial coach may aid an individual to overcome loss-aversion bias or overconfidence bias that results in completely avoiding the setting of financial goals or pursuing financial freedom through a higher-than-appropriate risk appetite. Financial literacy awareness would not only encourage individuals to create goals for savings, but financial coaching can guide individuals on financial/ investment strategies to avoid mistakes resulting from cognitive biases such as herding and confirmation bias. This can occur when individuals’ base decisions on intuition, herd mentality and feelings rather than financial market facts.
Choice architecture interventions or “nudges”: Nudging is one of the better-known behavioural techniques available to policymakers to induce individuals toward better decisions without banning or limiting their choice. Through nudging tools such as default settings, automatic enrolments – e.g. employees are automatically enrolled in pension plans, reminders, simplification of processes etc., individuals’ environments can be altered to steer them in the direction of better financial decision making and to aid in overcoming behavioural biases. Nudging can overcome both emotional biases such as status-quo bias and cognitive biases such as risk-aversion.
Conclusion
Conclusively, the application of behavioural insights in policy making may be considered as a tool to inform and enhance the effectiveness of proposed policies. In financial decision making, individual education programmes and financial literacy initiatives are important, however by using behavioural insights, these can be targeted and can help improve financial literacy, due to the complex nature of financial products, risk inherent in these products, and the impact biases have on decision-making [3]. Understanding what motivates people and what drives behaviour is vital in designing policies for the achievement of developmental goals. The key benefits of this approach to financial policy development include informed savings and investment decision-making, better financial planning, and greater confidence and participation in the financial and securities markets, and the encouragement of wealth creation for citizens [3]
References
https://openknowledge.worldbank.org/entities/publication/b5650982-1f49-5927-94ad-9f4dfcd83181
OECD (2018) The Application of behavioral insights to financial literacy and investor education programmes and initiatives.
Josephat Lotto (2022). Household savings patterns and behaviour in East Africa. Cogent Business & Management (2022), 9: 2101418.
World Bank (2021). The Global Findex Database. Financial inclusion, Digital payments, and resilience in the Age of Covid 19.
Author's bio
Balisa Mhambi is an African development enthusiast with extensive research expertise and experience in public policy and regulation in Competition Law & Policy, Financial Inclusion, Behavioural Economics, and Economic Development. She is a Competition Analyst with the National Energy Regulator of South Africa (NERSA). She holds an MCom degree in Economics and she is currently enrolled for a PhD in Economics.
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