The persistence of cognitive biases in financial decisions across economic groups

5: Behavioural biases in personal finance

Behavioural economics merges psychology and economics to explore systematic deviations in financial decision-making from traditional economic models. This chapter examines key biases such as mental accounting, present bias, planning fallacy, and misunderstanding of risk, which influence spending, saving, investing, and insuring decisions. Demonstrating the interplay of cognitive biases and heuristics highlights why individuals make suboptimal choices despite financial literacy and resource capacity. Strategies like goal-setting, commitment devices, and education interventions are evaluated, focusing on their limitations and potential for addressing these biases. The chapter concludes by emphasising the need for systemic changes, such as policy-level interventions and financial regulation, to complement behavioural interventions and address structural barriers to better financial decisions. Future research directions are suggested, including tailoring interventions, exploring technology's role, and integrating systemic solutions to support sustainable financial well-being.

Behaviorally Informed Policies for Household Financial Decisionmaking

Low incomes, limited financial literacy, fraud, and deception are just a few of the many intractable economic and social factors that contribute to the financial difficulties that households face today. Addressing these issues directly is difficult and costly. But poor financial outcomes also result from systematic psychological tendencies, including imperfect optimization, biased judgments and preferences, and susceptibility to influence by the actions and opinions of others. Some of these psychological tendencies and the problems they cause may be countered by policies and interventions that are both low cost and scalable. We detail the ways that these behavioral factors contribute to consumers’ fiancial mistakes and suggest a set of interventions that the federal government, in its dual roles as regulator and employer, could feasibly test or implement to improve household financial outcomes in a variety of domains: retirement, short-term savings, debt management, the take-up of government benefits, and tax optimization.

Reducing debt improves psychological functioning and changes decision-making in the poor

Significance The impact of chronic debt on the poor is psychological, not just financial. We hypothesize that chronic debt impairs psychological functioning and decision-making, contributing to the poverty trap. This is because debt is not considered fungible and is viewed as costly mental accounts that consume cognitive bandwidth. We test this using quasiexperimental evidence from a one-off, unanticipated debt-relief program worth several months’ household income. Comparing the poor before and after debt relief, those with more debt accounts paid off experienced greater improvements in cognitive functioning, reported less anxiety, and became less present-biased. These findings provide actionable evidence for poverty-alleviation policy. , We examine how chronic debt affects behavior by studying how a large, unanticipated debt-relief program affected psychological functioning and economic decision-making in beneficiaries. A charity granted low-income households debt relief worth up to Singapore dollars 5,000 (∼3 month’s household income). We exploited quasiexperimental variation in the structure of debt relief: For the same dollar amount of relief, some beneficiaries had more debt accounts eliminated, while others had fewer paid off. Comparing 196 beneficiaries before and after debt relief, and controlling for debt-relief amount, having an additional debt account paid off improves cognitive functioning by about one-quarter of a SD and reduces the likelihood of exhibiting anxiety by 11% and of present bias by 10%. To achieve the same effect on cognitive functioning of eliminating one debt account, a beneficiary must receive debt relief worth ∼1 month’s household income. There is no effect of debt-relief magnitude on anxiety and decision-making. We exclude training and calendar effects, debt-causing behaviors, and liquidity constraints as explanations. Instead, these results support the hypothesis that chronic debt impairs behavior because the mental-accounting costs of owing distinct debt accounts consume mental bandwidth. Poverty-alleviation policies aimed at the indebted poor should consider addressing mental accounting and bandwidth taxes.

Behavioral Impediments to Valuing Annuities: Complexity and Choice Bracketing

Abstract This paper examines two behavioral factors that diminish people's ability to value a lifetime income stream or annuity, drawing on a randomized experiment with about 4,000 adults in a U.S. nationally representative sample. We find that increasing the complexity of the annuity choice reduces respondents' ability to value the annuity, measured by the difference between the sell and buy values they assign to the annuity. When we limit narrow choice bracketing by inducing people to think first about how quickly or slowly to spend down assets in retirement, their ability to value an annuity increases.

Identifying heterogeneity using recursive partitioning: evidence from SMS nudges encouraging voluntary retirement savings in Mexico

Abstract Individuals regularly struggle to save for retirement. Using a large-scale field experiment (N=97,149) in Mexico, we test the effectiveness of several behavioral interventions relative to existing policy and each other geared toward improving voluntary retirement savings contributions. We find that an intervention framing savings as a way to secure one’s family future significantly improves contribution rates. We leverage recursive partitioning techniques and identify that the overall positive treatment effect masks subpopulations where the treatment is even more effective and other groups where the treatment has a significant negative effect, decreasing contribution rates. Accounting for this variation is significant for theoretical and policy development as well as firm profitability. Our work also provides a methodological framework for how to better design, scale, and deploy behavioral interventions to maximize their effectiveness.

Do people like financial nudges?

Do people like financial nudges? To answer that question we conducted a pre-registered survey presenting people with 36 hypothetical scenarios describing financial interventions. We varied levels of transparency (i.e., explaining how the interventions worked), framing (interventions framed in terms of spending, or saving), and ‘System’ (interventions could target either System 1 or System 2). Participants were a random sample of 2,100 people drawn from a representative Australian population. All financial interventions were tested across six dependent variables: approval, benefit, ethics, manipulation, the likelihood of use, as well as the likelihood of use if the intervention were to be proposed by a bank. Results indicate that people generally approve of financial interventions, rating them as neutral to positive across all dependent variables (except for manipulation, which was reverse coded). We find effects of framing and System. People have strong and significant preferences for System 2 interventions, and interventions framed in terms of savings. Transparency was not found to have a significant impact on how people rate financial interventions. Financial interventions continue to be rated positive, regardless of the messenger. Looking at demographics, we find that participants who were female, younger, living in metro areas and earning higher incomes were most likely to favor financial interventions, and this effect is especially strong for those aged under 45. We discuss the implications for these results as applied to the financial sector.

Psychological ownership interventions increase interest in claiming government benefits

Significance Most government benefits programs exhibit a sizable participation gap, with eligible individuals forgoing billions of dollars in government benefits each year. Many policymakers have focused on addressing this participation gap, as receiving government benefits has been shown to reduce poverty, childhood hunger, educational gaps, and physical and mental illness. The current work presents psychological ownership framing as a behavioral science intervention, and we show that it can help address this benefits participation gap. These interventions are subtle, simple to implement, and cheaper to execute relative to logistical interventions. Moreover, the data show that psychological ownership interventions can be more efficacious than other common psychological interventions such as social norms and urgency. , Each year, eligible individuals forgo billions of dollars in financial assistance in the form of government benefits. To address this participation gap, we identify psychological ownership of government benefits as a factor that significantly influences individuals’ interest in applying for government benefits. Psychological ownership refers to how much an individual feels that a target is their own. We propose that the more individuals feel that government benefits are their own, the less likely they are to perceive applying for them as an aversive ask for help, and thus, the more likely they are to pursue them. Three large-scale field experiments among low-income individuals demonstrate that higher psychological ownership framing of government benefits significantly increases participants’ pursuit of benefits and outperforms other common psychological interventions. An additional experiment shows that this effect occurs because greater psychological ownership reduces people’s general aversion to asking for assistance. Relative to control messages, these psychological ownership interventions increased interest in claiming government benefits by 20% to 128%. These results suggest that psychological ownership framing is an effective tool in the portfolio of potential behavioral science interventions and a simple way to stimulate interest in claiming benefits.

Adult age differences in monetary decisions with real and hypothetical reward

Abstract Age differences in monetary decisions may emerge because younger and older adults perceive the value of outcomes differently. Yet, age‐differential effects of monetary rewards on decisions are not well understood. Most laboratory studies on aging and decision making have used scenarios in which rewards were merely hypothetical (decisions did not have any real consequences) or in which only small amounts of money were at stake. In the current study, we compared younger adults' (20–29 years) and older adults' (61–82 years) decisions in probabilistic choice problems with real or hypothetical rewards. Decision‐contingent rewards were in a typical range of previous studies (gains of up to ~4.25 USD) or substantially scaled up (gains of up to ~85 USD per participant). Reward type (real vs. hypothetical) affected decision quality, including value maximization, switching between options, and dominance violations (choices of an option that was inferior to another option in all respects). Decision quality was markedly better with real than hypothetical rewards in older adults and correlated with numeracy in both age groups. However, we found no evidence that reward type affected people's risk preferences. Overall, the findings portray a fairly positive picture regarding the use of hypothetical scenarios to assess preferences: With carefully prepared instructions, people from different age groups indicate preferences in hypothetical scenarios that match their decisions with real and much higher rewards. One advantage of using real rewards is that they help to reduce decision noise.

How Field Experiments in Economics Can Complement Psychological Research on Judgment Biases

This review summarizes results of field experiments examining individual behaviors across several market settings—from open-air markets to rideshare markets to tax-compliance markets—where people sort themselves into market roles wherein they make consequential decisions. Using three distinct examples from my own research on the endowment effect, left-digit bias, and omission bias, I showcase how field experiments can help researchers understand mediators, heterogeneity, and causal moderation involved in judgment biases in the field. In this manner, the review highlights that economic field experiments can serve an invaluable intellectual role alongside traditional laboratory research.

Knowing When to Spend: Unintended Financial Consequences of Earmarking to Encourage Savings

Maintaining savings is an important financial goal. Yet there are times when savings should be spent, such as when people face unavoidable costs, and spending their savings allows them to avoid high interest rate debt. Existing behavioral research has focused on consumer decisions between savings and discretionary spending and has proposed interventions to promote savings in these contexts. However, when spending is not discretionary, such interventions could risk exacerbating a pattern found in economic research in which people borrow high interest rate debt while maintaining savings that earn low levels of interest. To examine how mental accounting interacts with considerations of personal responsibility and guilt to contribute to this pattern, this article explores whether people spend their savings when they need money most: during emergencies. Six studies reveal that people's tendency to preserve savings by borrowing from a high interest rate credit option varies as a function of the savings’ intended use. Paradoxically, people are most likely to turn to high interest rate credit with the belief that doing so is the responsible option.

The Impact of Payment Frequency on Consumer Spending and Subjective Wealth Perceptions

Abstract Payment frequency is a fundamental yet underexplored feature of consumers’ finances. As higher payment frequencies are becoming more prevalent, consumers are receiving more frequent yet smaller paychecks. An analysis of income and expenditure data of over 30,000 consumers from a financial services provider demonstrates a naturally occurring relationship between higher payment frequencies and increased spending. A series of lab studies support this finding, providing causal evidence that higher (vs. lower) payment frequencies increase spending. The effect of payment frequency on spending is driven by changes in consumers’ subjective wealth perceptions. Specifically, higher payment frequencies reduce consumers’ uncertainty in predicting whether they will have enough resources throughout a period, increasing their subjective wealth perceptions. As such, situational factors that reduce prediction uncertainty for those paid less frequently (e.g., the timing of consumers’ expenses, income levels) moderate the impact of payment frequency. The effects of payment frequency on subjective wealth and spending can occur even when objective wealth favors those with lower payment frequencies. More broadly, the current work underscores a need to understand how timing variations in consumers’ income impact their perceptions, behaviors, and general well-being.

Choice Bracketing

When making many choices, a person can broadly bracket them by assessing the consequences of all of them taken together, or narrowly bracket them by making each choice in isolation. We integrate research conducted in a wide range of decision contexts which shows that choice bracketing is an important determinant of behavior. Because broad bracketing allows people to take into account all the consequences of their actions, it generally leads to choices that yield higher utility. The evidence that we review, however, shows that people often fail to bracket broadly when it would be feasible for them to do so. In addition to documenting the diverse effects of bracketing, we also discuss factors that determine whether people bracket narrowly or broadly. We conclude with a discussion of normative aspects of bracketing and argue that there are some situations in which narrower bracketing results in superior decision making.

What Would You Do with $500? Spending Responses to Gains, Losses, News, and Loans

Abstract We use survey questions about spending in hypothetical scenarios to investigate features of propensities to consume that are useful for distinguishing between consumption theories. We find that (1) responses to unanticipated gains are vastly heterogeneous (either zero or substantially positive); (2) responses increase in the size of the gain, driven by the extensive margin of spending adjustments; (3) responses to losses are much larger and more widespread than responses to gains; and (4) even those with large responses to gains do not respond to news about future gains. These four findings suggest that limited access to disposable resources, and frictions in adjusting consumption, are important determinants of consumption behaviour. We also find that (5) households do not respond to the offer of a one-year interest-free loan, suggesting that this is not a consequence of short-term credit constraints; and (6) people do cut spending in response to news about future losses, suggesting that neither is this a consequence of myopia. A calibrated precautionary savings model with utility costs of changing consumption, and a sufficient fraction of low-wealth households, can account for these features of propensities to consume on both the extensive and intensive margins.

Household Finance

Household financial decisions are complex, interdependent, and heterogeneous, and central to the functioning of the financial system. We present an overview of the rapidly expanding literature on household finance (with some important exceptions) and suggest directions for future research. We begin with the theory and empirics of asset market participation and asset allocation over the life cycle. We then discuss household choices in insurance markets, trading behavior, decisions on retirement saving, and financial choices by retirees. We survey research on liabilities, including mortgage choice, refinancing, and default, and household behavior in unsecured credit markets, including credit cards and payday lending. We then connect the household to its social environment, including peer effects, cultural and hereditary factors, intra-household financial decision-making, financial literacy, cognition, and educational interventions. We also discuss literature on the provision and consumption of financial advice.

Financial Literacy, Financial Education, and Downstream Financial Behaviors

Policy makers have embraced financial education as a necessary antidote to the increasing complexity of consumers' financial decisions over the last generation. We conduct a meta-analysis of the relationship of financial literacy and of financial education to financial behaviors in 168 papers covering 201 prior studies. We find that interventions to improve financial literacy explain only 0.1% of the variance in financial behaviors studied, with weaker effects in low-income samples. Like other education, financial education decays over time; even large interventions with many hours of instruction have negligible effects on behavior 20 months or more from the time of intervention. Correlational studies that measure financial literacy find stronger associations with financial behaviors. We conduct three empirical studies, and we find that the partial effects of financial literacy diminish dramatically when one controls for psychological traits that have been omitted in prior research or when one uses an instrument for financial literacy to control for omitted variables. Financial education as studied to date has serious limitations that have been masked by the apparently larger effects in correlational studies. We envisage a reduced role for financial education that is not elaborated or acted upon soon afterward. We suggest a real but narrower role for “just-in-time” financial education tied to specific behaviors it intends to help. We conclude with a discussion of the characteristics of behaviors that might affect the policy maker's mix of financial education, choice architecture, and regulation as tools to help consumer financial behavior. This paper was accepted by Uri Gneezy, behavioral economics.

Echo Chambers and Their Effects on Economic and Political Outcomes

In this review, we survey the economics literature on echo chambers. We identify echo chambers as arising from a combination of two phenomena: ( a) the choice of individuals to segregate with like-minded ones, i.e., the creation of chambers, and ( b) behavioral biases that induce polarization when individuals exchange beliefs in these chambers, i.e., the echo. We summarize the literatures on these two phenomena and suggest how to combine the two literatures to gain insights about the effects of echo chambers on economic and political outcomes. We end by suggesting pathways for future research and discussing policy interventions to alleviate echo chambers.