There is a ‘new term’ in town: ‘Behavioural economics’. Actually it’s really just a fancy term for concepts that have been in play for the best part of 30 years, but recent developments in neuroscience have added to the field. What is being discovered may affect everyone who has ever purchased a financial product (i.e. everyone reading this) and all organisations that have ever sold them.
‘What was I thinking?’
You probably think that you make rational financial decisions most of the time, right? That may well be the case, but many of us don’t. Anyone who has ever wondered ‘what was I thinking when I bought those shares?’ or similar, will know what I am talking about.
We like to think we make decisions objectively and after sufficient deliberation but studies from psychology and neuroscience consistently show that many of our decisions are driven by our in-built biases or ‘cognitive biases’. These are developed early in our lives and usually persist, so we often tend to respond intuitively or emotionally rather than rationally and deliberately.
This can lead to poor judgement in many walks of life and most of the time it need not have serious consequences – we are all humans and we make mistakes. However, when it can result in financial collapse like it did for many during the Global Financial Crisis it becomes necessary to get the decision right, and to look into the reasons why that may not be possible.
This is where behavioural economics comes in. The interest in why even sophisticated people choose an inferior product – even when a more suitable product is available – has intrigued many economists, financial institutions, and behavioural psychologists alike.
Since the groundbreaking work of Nobel Prize-winning psychologist Daniel Kahneman in the 1980s the theories have been floating around; but with additional findings from neuroscience about how we think and behave, plus the influence of the Global Financial Crisis, interest has started rise.
More and more work has gone into answering two main questions:
1. Why do so many consumers make ‘sub-optimal’ decisions when selecting financial products?
2. Why do they choose poor products over products that are better suited to their needs?
Behavioural economics sets out to quantify financial decision-making and take a more ‘scientific’ approach to it. The tendency in the past was to just ‘assume’ that people make decisions armed with all the right information.
The GFC showed that this didn’t necessarily apply – and the fallout affected countless millions of people. So the regulators in the UK, Europe, the US and Australia have all become interested.
The Financial Conduct Authority (FCA) in the UK says ‘Behavioural economics takes us beyond intuition and helps us be precise in detecting, understanding, and remedying problems that arise from consumer mistakes.’
How does it affect financial organisations?
Many financial institutions have come under the spotlight for their marketing strategies in recent years. Fingers point at attempts to exploit customer decision-making by appealing to their biases, knowingly leading them to less effective choices than alternatives or competing products.
Because of interest from financial market regulators about these practices, it is only a matter of time before financial products and services come under the hammer from regulators again, in an effort to protect customers. Financial products are often complex, but they can be presented as deliberately confusing or misleading, and the regulators will be targeting this. Financial institutions will need to examine how their range of products and services are presented to their customers to make features more transparent.
The main area of dispute here is where the line will be drawn between effective marketing and ‘unethical’ manipulation of decision-making.
As with any regulatory change, this is an opportunity for financial institutions to differentiate themselves in the market by leading the way and preparing for the changes that the rise of behavioural economics will bring about.