Insights From Behavioral Economics For Personal Finance
Insights from Behavioral Economics for Personal Finance Stephan Meier (Columbia University GSB) FRB New York January, 2010 Stephan Meier (Columbia U) Behavioral Economics and Personal Finance
Introduction Assumptions of Behavioral Economics Mainstream Economics Standard (or “classical”) assumptions: People know what’s in their best interest And they act on that knowledge Competition between firms takes care of the rest Minimal regulatory intervention Stephan Meier (Columbia U) Behavioral Economics and Personal Finance
Introduction Assumptions of Behavioral Economics Behavioral Economics More realistic assumptions: People sometimes get confused - E.g., don’t understand mortgage terms And even when we do understand what’s best, we often don’t follow through - E.g., want to borrow less (save more) – tomorrow Psychology & Economics Suboptimal decisions Regulation might be needed Stephan Meier (Columbia U) Behavioral Economics and Personal Finance
Introduction Assumptions of Behavioral Economics Behavioral Finance Use psychology and economics to understand finance: Asset Pricing Corporate Finance Personal Finance Price Anomalies IPO underperformance Value Anomaly Sentiment Equity premium PEA drift Momentum Bubbles IPO timing Winner’s curse Cash-flow sensitivity Overconfidence Superstar CEO’s Present Bias Emotional choice Loss aversion Narrow Framing Return chasing Financial illiteracy Home bias Overconfidence Wishful thinking Stephan Meier (Columbia U) Behavioral Economics and Personal Finance
Introduction Assumptions of Behavioral Economics Behavioral Finance Use psychology and economics to understand finance: Asset Pricing Corporate Finance Personal Finance Price Anomalies IPO underperformance Value Anomaly Sentiment Equity premium PEA drift Momentum Bubbles IPO timing Winner’s curse Cash-flow sensitivity Overconfidence Superstar CEO’s Present Bias Emotional choice Loss aversion Narrow Framing Return chasing Financial illiteracy Home bias Overconfidence Wishful thinking Stephan Meier (Columbia U) Behavioral Economics and Personal Finance
Outline 1 Present-Bias and Credit Cards 2 Numerical Ability and Mortgages 3 Will consumers learn? Stephan Meier (Columbia U) Behavioral Economics and Personal Finance
Present-Bias and Credit Cards Present-Biased Preferences Present-Biased Preferences Thought experiment (Read and van Leeuwen, 1998): Deciding today, would you choose fruit or chocolate for next week? - 74% choose fruit Deciding today, would you choose fruit or chocolate for today? - 70% choose chocolate The effect of present bias: People may value the present too much given their long-run plan dynamic inconsistency Instantaneous benefits trigger affective decision-making system (McClure et al. 2007) Difference in present-bias exist already in small kids (Mischel et al. 1989) Overborrowing given long-run plan (discount factor) Stephan Meier (Columbia U) Behavioral Economics and Personal Finance
Present-Bias and Credit Cards Present-Biased Preferences Present-Biased Preferences Thought experiment (Read and van Leeuwen, 1998): Deciding today, would you choose fruit or chocolate for next week? - 74% choose fruit Deciding today, would you choose fruit or chocolate for today? - 70% choose chocolate The effect of present bias: People may value the present too much given their long-run plan dynamic inconsistency Instantaneous benefits trigger affective decision-making system (McClure et al. 2007) Difference in present-bias exist already in small kids (Mischel et al. 1989) Overborrowing given long-run plan (discount factor) Stephan Meier (Columbia U) Behavioral Economics and Personal Finance
Present-Bias and Credit Cards Present-Biased Preferences Present-Biased Preferences Thought experiment (Read and van Leeuwen, 1998): Deciding today, would you choose fruit or chocolate for next week? - 74% choose fruit Deciding today, would you choose fruit or chocolate for today? - 70% choose chocolate The effect of present bias: People may value the present too much given their long-run plan dynamic inconsistency Instantaneous benefits trigger affective decision-making system (McClure et al. 2007) Difference in present-bias exist already in small kids (Mischel et al. 1989) Overborrowing given long-run plan (discount factor) Stephan Meier (Columbia U) Behavioral Economics and Personal Finance
Present-Bias and Credit Cards Present-Biased Preferences Present-Biased Preferences Thought experiment (Read and van Leeuwen, 1998): Deciding today, would you choose fruit or chocolate for next week? - 74% choose fruit Deciding today, would you choose fruit or chocolate for today? - 70% choose chocolate The effect of present bias: People may value the present too much given their long-run plan dynamic inconsistency Instantaneous benefits trigger affective decision-making system (McClure et al. 2007) Difference in present-bias exist already in small kids (Mischel et al. 1989) Overborrowing given long-run plan (discount factor) Stephan Meier (Columbia U) Behavioral Economics and Personal Finance
Present-Bias and Credit Cards Present-Biased Preferences Present-Biased Preferences Thought experiment (Read and van Leeuwen, 1998): Deciding today, would you choose fruit or chocolate for next week? - 74% choose fruit Deciding today, would you choose fruit or chocolate for today? - 70% choose chocolate The effect of present bias: People may value the present too much given their long-run plan dynamic inconsistency Instantaneous benefits trigger affective decision-making system (McClure et al. 2007) Difference in present-bias exist already in small kids (Mischel et al. 1989) Overborrowing given long-run plan (discount factor) Stephan Meier (Columbia U) Behavioral Economics and Personal Finance
Present-Bias and Credit Cards Effect on Credit Card Borrowing Present Bias and Credit Card Borrowing (Meier and Sprenger, AEJ: Applied, 2010) Is there a direct link between dynamic inconsistency and credit card borrowing? Study at a volunteer tax income assistance (VITA) site Individuals get help filing their taxes Selection of LMI individuals Two key parts of the study 1 2 Experimental measurement of time preferences: individual-level measure of present bias Accurate measurement of debt through use of credit records Stephan Meier (Columbia U) Behavioral Economics and Personal Finance
Present-Bias and Credit Cards Results Outstanding Balance on Revolving Accounts Note: N 541. p 0.01 in t test. The association between present bias and credit card balance is robust to (1) controlling for socio-demographic variables, (2) controlling for credit limits and fico scores, (3) using credit card balance one year after choice experiment as dependent variable, . . . Stephan Meier (Columbia U) Behavioral Economics and Personal Finance
Present-Bias and Credit Cards Results Present-bias can explain various consumer mistakes Randomized study by major card issuer (Shui & Ausubel, 2004): Teaser rates Consumers don’t switch to lower interest cards 250 pa Consumers prefer 4.9% for 6 months over 7.9% for 12 50 Study by Gross & Souleles (2002): 90% of revolvers have liquid assets 200 pa Randomized study by U.S. bank (Agarwal et al., 2007): 40% make wrong choice between ‘no fee/lower r ’ and ‘fee/higher r ’ Study of dataset of large financial institution (Agarwal et al. 2009): 28% make clear mistakes leading to substantial fees . . . even thought they had enough money (Massoud et al., 2007) Consumers make substantial mistakes in balance-transfer options Stephan Meier (Columbia U) Behavioral Economics and Personal Finance
Present-Bias and Credit Cards Results Other Evidence on Effects of Present Bias Laibson, Repetto & Tobacman (2007): savings Della Vigna & Maldemendier (2004, 2006): gym membership Ashraf & Karlan (2004): commitment savings Della Vigna and Paserman (2005): job search Duflo (2009): immunization Duflo, Kremer, Robinson (2009): commitment fertilizer Karlan & Zinman (2009): commitment to stop smoking Milkman et al (2008): video rentals return sequencing Oster & Scott-Morton (2005): magazine marketing/sales Thornton (2005): HIV testing Trope & Fischbach (2000): commitment to medical adherence Wertenbroch (1998): individual packaging Stephan Meier (Columbia U) Behavioral Economics and Personal Finance
Numerical Ability and Mortgages Is Financial Illiteracy Associated with Defaults? Source: The Economist. Stephan Meier (Columbia U) Behavioral Economics and Personal Finance
Numerical Ability and Mortgages The Effect of Limited Numerical Abilities Limited numerical ability may cause . . . Inappropriate reaction to income / consumption shocks Gullible when confronted with complicated contracts Impatience, because interest rate seems low in short run Affects ability to compare offers Indeed, recent research suggests that numerical abilities are associated with worse consumption / savings outcomes (Banks and Oldfield, 2007; Lusardi and Mitchell, 2009) Is numerical ability also associated with mortgage defaults? Stephan Meier (Columbia U) Behavioral Economics and Personal Finance
Numerical Ability and Mortgages Rationality and Credit Markets Are borrower well-equipped to make financial decisions? 1 Borrowers make informed decisions “(. . . ) I am more open to the idea that some borrowers were making rational decisions about risk and rewards.” (Ian Ayres in NYtimes.com, October 14, 2008) 2 Borrowers make uninformed decisions ‘‘Many (. . . ) buyers who took out high loan-to-value mortgages with adjustable rates did not have ready access to information about what they were doing (. . . ) and so made serious mistakes” (Robert Shiller in Wall Street Journal, October 9th, 2008) No study so far, investigating mortgages and numerical abilities Stephan Meier (Columbia U) Behavioral Economics and Personal Finance
Numerical Ability and Mortgages Study on Numerical Ability and Mortgage Defaults (Gerardi, Goette and Meier, 2010) We conducted a survey with borrowers and asked info about mortgage socio-demographics preference parameters cognitive ability numerical ability . . . . and then match it to data from the registry of deeds and loan performance data Important details: Survey in 2008 for subprime mortgages issued in ’06 and ’07 in MA, CT and RI Stephan Meier (Columbia U) Behavioral Economics and Personal Finance
Numerical Ability and Mortgages Measuring Numerical Ability Numerical Ability Questions (Banks and Oldfield, 2007) 1 In a sale, a shop is selling all items at half price. Before the sale, a sofa costs 300. How much will it cost in the sale? 2 If the chance of getting a disease is 10 per cent, how many people out of 1,000 would be expected to get the disease? 3 A second hand car dealer is selling a car for 6,000. This is two-thirds of what it cost new. How much did the car cost new? 4 If 5 people all have the winning numbers in the lottery and the prize is 2 million, how much will each of them get? 5 Let’s say you have 200 in a savings account. The account earns ten per cent interest per year. How much will you have in the account at the end of two years? Banks and Oldfield (2007) suggest division into four groups: Group This study: Banks and Oldfield (2007): 1 15.6% 16.2% Stephan Meier (Columbia U) 2 53.9% 46.6% 3 17.1% 26.8% 4 13.3% 11.1% Behavioral Economics and Personal Finance
Numerical Ability and Mortgages Knowledge About Mortgage Terms .7 30% .7 .6 .5 .4 .3 .2 Proportion who III: III IV: Financial Raw Including worst best Differences think think Literacy Control they FRM of ARM have while Variables Groups holders FRM having ARM! Proportion of ARM holders who think they have FRM .3 .4 .5 .6 Raw Differences Including Control Variables .2 30% think FRM while having ARM! I: worst II III IV: best Financial Literacy Groups Note: N 208. Control variables: Socio-demographics. Stephan Meier (Columbia U) Behavioral Economics and Personal Finance
Numerical Ability and Mortgages Raw Correlations: % of Time Delinquent (N 339) .05 0 .3 .25 .2 .15 .1 .05 Fraction 1 2 3 4 Financial Panel A:of Literacy Percent periodsGroup of behind Timeon Delinquent payments .25 .2 .15 .1 .05 0 Fraction of periods behind on payments .3 Panel A: Percent of Time Delinquent 1 2 3 4 Financial Literacy Group Stephan Meier (Columbia U) Behavioral Economics and Personal Finance
Numerical Ability and Mortgages Raw Correlations: Frequency of Foreclosure Petitions .05 0 .3 .25 .2 .15 .1 .05 Fraction 1 2 3 4 Financial Panel C: ever Literacy Frequency entering Group offoreclosure Foreclosure Petitions .25 .2 .15 .1 .05 0 Fraction ever entering foreclosure .3 Panel C: Frequency of Foreclosure Petitions 1 2 3 4 Financial Literacy Group Stephan Meier (Columbia U) Behavioral Economics and Personal Finance
Numerical Ability and Mortgages Interpretation Strong and significant association between numerical ability and delinquency Robust to including a wide range of control variables Association with three different measures of delinquencies What is the channel of this association? Stephan Meier (Columbia U) Behavioral Economics and Personal Finance
Narrowing Down the Channels Narrowing Down the Channels 1 Which aspect of cognitive abilities is related to delinquencies? General cognitive abilities, economic literacy, or numerical ability? Control for general IQ and economic literacy It is numerical ability! 2 Is the effect mediated by the choice of poorer mortgage terms? Control for mortgage details (FRM, LTV, DTI, Low Doc) Effect of numerical ability on delinquency is not mediated through poor choice of mortgage conditions! Stephan Meier (Columbia U) Behavioral Economics and Personal Finance
Narrowing Down the Channels Effects of Financial Illiteracy on Mortgages Results show that limited numerical ability/financial literacy is substantially associated with defaults In general, understanding mortgage contracts is challenging Various known consumer mistakes: At least 40% who have subprime mortages would have qualified for prime mortgage (NTIC, 2002) Persistent consumer mistakes in home equity loans (Agarwal et al. 2008) Substantial refinance mistakes (Campell 2008) 25% of loan value Stephan Meier (Columbia U) Behavioral Economics and Personal Finance
Narrowing Down the Channels Conclusion I 1 Many don’t fully understand details of financial products 2 Psychological factors makes it hard to stick to long-run plans Fee structure, teaser rates, etc make it harder for some individuals A number of consumers make suboptimal decisions But don’t they learn? Stephan Meier (Columbia U) Behavioral Economics and Personal Finance
Narrowing Down the Channels Do Consumers Learn to Avoid Mistakes? Not really! Many are uninformed. Why? People are not aware of mistakes People discount the future benefits (Meier & Sprenger, 2008) High cost of getting informed ‘Recency effect’ in learning (Agarwal et al. 2009) Many subprime borrowers don’t seek advise or shop around (Gerardi et al., 2010) Education programs have limited effects Stephan Meier (Columbia U) Behavioral Economics and Personal Finance
Narrowing Down the Channels Conclusion II Assumptions in ‘traditional’ economics need revision: Some consumers are confused Some don’t act in long-run best interest Consumers make (substantially) suboptimal decisions Credit markets are particularly prone for mistakes, due to. . . Complexity of products Intertemporal decision Limited incentives of firms to ‘educate’ consumers Difficulties to learn The question is how to helping those borrowers without hurting the ‘rational’ borrowers? Stephan Meier (Columbia U) Behavioral Economics and Personal Finance
THANK YOU! Stephan Meier (Columbia U) Behavioral Economics and Personal Finance
Additional Material Present-Biased Preferences Measurement of Time Preferences Choices between a smaller reward ( X ) in period t and a larger reward ( Y X ) in t d t Two time frames for choices: - Today vs. 1 month d 1 month - 6 months vs. 7 months d 1 month Choices allow to identify long-run discount factor δ and present-bias β - Individual discount factor: 0.83 - 36% exhibit present-bias Stephan Meier (Columbia U) Behavioral Economics and Personal Finance
Additional Material Present-Biased Preferences Design of Choice Experiments t 0, d 1: Option A (TODAY) or Option B (IN A MONTH) Decision (1): Decision (2): Decision (3): Decision (4): Decision (5): Decision (6): 75 guaranteed today - 80 guaranteed in a month 70 guaranteed today - 80 guaranteed in a month 65 guaranteed today - 80 guaranteed in a month 60 guaranteed today - 80 guaranteed in a month 50 guaranteed today - 80 guaranteed in a month 40 guaranteed today - 80 guaranteed in a month t 6, d 1: Option A (IN 6 MONTHS) or Option B (IN 7 MONTHS) Decision (1): Decision (2): Decision (3): Decision (4): Decision (5): Decision (6): 75 guaranteed in 6 months - 80 guaranteed in 7 months 70 guaranteed in 6 months - 80 guaranteed in 7 months 65 guaranteed in 6 months - 80 guaranteed in 7 months 60 guaranteed in 6 months - 80 guaranteed in 7 months 50 guaranteed in 6 months - 80 guaranteed in 7 months 40 guaranteed in 6 months - 80 guaranteed in 7 months Stephan Meier (Columbia U) Behavioral Economics and Personal Finance
Stephan Meier (Columbia U) Behavioral Economics and Personal Finance. Numerical Ability and Mortgages Knowledge About Mortgage Terms 30% think FRM while having ARM! 30% think FRM while having ARM!.2.2.3.3.4.4.5.5.6.6.7.7 Proportion of ARM holders Proportion of ARM holders who think they have FRM who think they have FRM
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