Why Consumers Make Bad Financial Decisions, and How Simple Policy Changes Can Help
New paper examines the psychological reasons that consumers make financial blunders and offers institutional remedies to help change those behaviors
Newswise — In an ideal world, consumers are making investment and monetary decisions based on facts and thorough research of the markets, careful analysis, and guidance from seasoned financial experts. Think again.
In the paper, "Behaviorally Informed Policies for Household Financial Decisionmaking," by a working group of behavioral scientists including University of Chicago Booth School of Business Associate Professor Abigail Sussman, researchers find that financial mistakes happen when consumers fail to examine all of their choices when making monetary decisions. For instance, many home buyers don't comparison shop when applying for a mortgage; they simply go with the first financial institution they contact.
All too often, individuals “focus on limited local trade-offs, instead of broad outcomes, leading to inefficient spending, borrowing, and investment outcomes," the researchers said in the paper.
Social context also plays a role. Individuals may look to the choices others make for guidance, and they may be motivated to make choices in part based on how others perceive their decisions.
Trust is another factor. Consumers sometimes either have too much trust in financial advisors, who may be motivated by their own self-interests, or too little trust, which may lead them to squirrel money away in low-return savings accounts instead of investing in the stock market. Meanwhile, distrust of institutions and social stigma may deter people from claiming financial benefits to which they are entitled, such as welfare, disability and unemployment insurance benefits.
These less-than-stellar money choices help contribute to the nation's $14.5 trillion in household liabilities, which include consumer mortgages, credit card debt, and other loans.
The paper provides solutions that institutions and employers can implement to help the public make better financial choices. For instance, they can improve retirement outcomes through automatic enrollments in 401(k) plans, "which simplifies the decision about whether to save and forestalls procrastination," according to the paper.
In addition, the federal government can help individuals save for short-term needs by reminding and encouraging IRS tax filers with a history of receiving refunds to make concrete plans about depositing these monies into savings accounts.
Managing personal debt of all kinds is another big area for improvement, as "individuals face difficult and costly decisions when it comes to debt," the study points out.
Credit card companies, for example, could facilitate better decision making by providing visualization tools to help consumers see the effects of compound interest. Credit card holders would benefit also from real-time notifications about just-incurred charges and upcoming and ongoing fees.
Payday loans, which consumers may not be able to repay when they come due, would be eased by the following: having employers provide a worksheet to help consumers make concrete plans about timely loan repayment and encouraging at least partial repayment if full repayment cannot be made.
As for mortgages, the Consumer Financial Protection Bureau can help individuals select the mortgage that is best for them by collecting basic information from prospective borrowers and then providing options that work best for an individual’s specific financial scenario.
The study also offers suggestions for improving benefits for low-income households and improving tax outcomes for individuals.
The other co-authors of the research were Brigitte Madrian, Harvard University; Hal Hershfield and Suzanne Shu, University of California, Los Angeles; Saurabh Bhargava, Carnegie Mellon University; Jeremy Burke, University of Southern California; Scott Huettel, Duke University; Julian Jamison, The World Bank; Eric Johnson and Stephan Meier, Columbia University; John Lynch, University of Colorado, Boulder; and Scott Rick, University of Michigan. They are all members of the Behavioral Science & Policy Association Working Group on Financial Decisionmaking.