Behavioural Economics Meets Financial Services Regulation
“For standalone insurance with a single price there were almost no mistakes in choosing the best deal. It is arithmetic we can handle. When it came to comparing offers with prices for a main product, as well as a separate price for an add-on without a total, we start to see problems emerge.”
Martin Wheatley, Chief Executive Officer of the Financial Conduct Authority, (“FCA”), speaking at the Australian Securities and Investments Commission, Sydney.
As humans, we often make decisions that are not necessarily rational in the economic sense. This is because we are generally bad at mental calculations, heavily reliant on mental shortcuts and often allow our emotions to influence decision making. Together, these form cognitive biases and are the basis of behavioural economics, a relatively new science that combines the modelling of microeconomics with the behavioural insights of psychology.
Behavioural economics has been used to help explain why, for example, some doctors smoke even though they are fully aware of the negative effects and why we keep playing the lottery despite being fully aware of the terribly low odds of winning.
Since its conception, behavioural economics has grown in popularity and as a result has been applied to everything from marketing to public health. In the last year it has also found a purpose in the regulation of financial services.
With three occasional papers and a speech in Australia, the FCA has shown that it is placing a strong emphasis on how behavioural economics can help improve the financial industry for consumers. On various occasions, Martin Wheatley has publicly announced his vision of how the FCA seeks to use the science to improve market competition, improve consumer’s decision making processes, and eliminate products that take advantage of consumers’ bounded rationality.
“I want the FCA to use its new powers and remit to bring a more human face to the regulation of financial services.”
However, while highlighting how much the FCA values behavioural considerations in regulating financial services, the regulator has yet to indicate what this actually means for the financial industry. In the absence of a framework, we wanted to share some tips on how your business can incorporate behavioural insights into its operations, thus staying ahead of the FCA’s own aspirations.
Optimism Bias
Research has found that we are often overly optimistic about our future outcomes. While optimism is important in motivating us to persevere in the face of adversity, when it comes to financial planning, it can be harmful.
In the context of retirement planning, individuals may overestimate how much money they will have or, more detrimentally, underestimate how much money they will need. One suggested method to overcoming this bias would be to ask clients to write down in itemised detail what their expenditure will be during one year of retirement. This will ensure that they become concretely aware of how much money they actually need, and therefore, how much they need to be saving now. To add a further dose of reality, ask them to then calculate how many pay packets they will receive between now and when they plan on retiring to determine whether their goal is achievable.
Sleep on it
We often don’t realise it but we mostly use our fast-processing intuition to make decisions rather than our slow, more deliberative thought. This helps to explain why our decisions are prone to the various cognitive biases. It is because of this reason that Daniel Kahneman, writer of the seminal “Thinking Fast and Slow”, suggested that one of the simplest solutions to this problem is to merely “sleep on it”. Given additional time, you are less likely to make a decision affected by cognitive biases that stem from intuitive thinking.
By insisting that any major financial decisions are made the following day, firms can be sure beyond a lengthy ‘terms and conditions’ that their clients are making the decision that they truly feel is right for them. This is especially important during times when your clients have recently made significant profits through their investments and are at risk to the “hot hand fallacy”, the belief in a winning streak following a success.
Mental Accounting
People have a tendency to compartmentalise their money based on its intended purpose to help make financial decisions manageable. For example, many people will keep borrowing money to pay for everyday items while simply sitting on their savings. This is because they would rather pay the interest on a loan than to complicate their mental accounting by spending money they have mentally earmarked as their savings.
Therefore, when a client requests advice on a specific matter, such as pensions, it is important to take into consideration their entire profile and to account for any separately earmarked areas of their finances.
It isn’t just your clients.
These cognitive biases affect everyone including those who are aware of them. This is known as the ‘bias blind sight’ and it highlights the importance of developing systems and controls in place to ensure that even the savviest advisers do not fall prey to these biases when working with clients. From a preference for immediate rewards (hyperbolic discounting) to a desire to search only for information that confirms our established view or preference (confirmation bias), these biases are detrimental to clients as well as advisers.