Behavioural economics has been gaining a lot of attention from the financial services industry. The FCA issued an ‘occasional paper’ in April 2013 where they highlighted their intention to make behavioural economics a factor in the regulation of financial conduct.
So what exactly is behavioural economics? One suggested definition is as follows:
“A method of economic analysis that applies psychological insights in to human behaviour to explain the decisions that are reached”
Behavioural economics appreciates that far from being completely rational (as assumed by neo classical economics), humans are fundamentally swayed by a wide range of psychological influences when making financial decisions .It helps explain why the decisions we make may not always be entirely logical or aligned with maximising self interest.
Heuristics are the ‘rule of thumb’ techniques we use when making decisions. We sometimes refer to them as our educated guesses; in reality they tend to be experienced based although as we will see it doesn’t always have to be our own experience.
Different types of heuristics:
Anchoring – this is the common tendency to over-rely on one piece of information (anchor). For example, if you go to buy a second hand car with a sticker price of £10,000 you will always start your haggling around this figure and not at, say, £1.
Availability – this is the process by which we predict the frequency of an event occurring within the population, based on how easily the information can be brought to mind. You see a couple of news articles a few days apart of people winning the lottery, suddenly you feel that the chances of winning are much higher than the actual 1 in 14 million odds would suggest.
Representativeness – the representativeness heuristic is the tendency to judge the frequency or likelihood of an event by the extent to which it resembles the typical case. For example, in a series of 10 coin tosses, most people judge the series HHTTHTHTTH (where H is heads and T is tails) to be more likely than the series HHHHHHHHHH, even though both series are equally likely. The reason is that the first series looks more random than the second series. It “represents” our idea of what a random series should look like
As we can see these cognitive biases heavily influence our assessment of everyday events and as such play a major role in defining things like our aversion to loss.
Key principles of Behavioural Economics
There are 7 key principles to behavioural economics which are used to understand decision-making process[ii].
- Other peoples behaviour matters
- Habits are important
- People are motivated to ‘do the right thing’
- Peoples self-expectations influence how they behave
- People are loss averse
- People are bad at computation
- People need to feel involved and effective to make a change
Going through each principle would make for a very long read so instead let’s focus on most important of these key principles.
Whilst instinctively we believe that we are not influenced by others a number of major experiments have shown that this is not true
Other peoples behaviour matters
People do many things by observing others and copying; people are encouraged to continue to do things when they feel other people around them approve of their behaviour.
Whilst instinctively we believe that we are not influenced by others a number of major experiments have shown that this is not true.
For example have you ever walked down the street and seen someone looking up at something? You don’t know what they are looking at, you don’t really have the time to stand around and look but you can’t help but look up.
This principle was shown to work in a now infamous experiment by the Minnesotan tax department where in an attempt to get people to do their returns on time; they sent out four different letters to the population.
- Telling people what good their taxes are doing
- Threatening with fines for non completion
- Offering help if the client was unsure what to do
- This group were told that 90% of Minnesotan’s had already complied with their obligations.
Group 4 had the largest response. Threats and offers to help did not work as effectively as telling them everyone else had done it.
People are motivated to ‘do the right thing’
People are motivated, on the whole, to do what they believe to be the right thing. People will base these decisions one of two motivations:
Intrinsic – this is the internal belief of doing something because you believe it to be right or because it gives you a sense of satisfaction.
Extrinsic – these are all the external factors that can sometimes overpower your intrinsic motivations, e.g. deadlines or financial incentives
Firms have to be careful when designing any remuneration schemes so as to ensure that an person’s extrinsic motivations are not overruling their intrinsic motivations and thereby making them do things that aren’t right for the client. The recent fine relating to ‘grand in the hand’ bonuses for Lloyds TSB’s sales advisers compensation scheme is a sadly all too relevant example of where managerial pressure and or the lure of excess reward could have led some to override their innate desire to do what was best for clients.
People are bad at computation
We are naturally bad at calculations, especially anything linked to probabilities. While we believe that we can calculate things linked to the population with ease, in reality we are not very good at it.
Salience – people judge the likelihood of an outcome occurring by how easily the outcome can be brought to mind or imagined. They are said to rely primarily on evidence which is most easily available to them and/or evidence that has particular salience. As such, they usually overestimate the likelihood of outcomes that are particularly memorable, highly emotional or have happened recently.
For instance, the popularity of the movie Jaws created excitement around shark attack reports so people tend to assume that they are more likely to be killed by sharks than by falling aeroplane parts; while most people would agree with this the reality is that the latter is 30 times more likely.
Discounting – our preference is inconsistent over time e.g. if you ask someone to do an unpleasant task for 5 hours today or 5.5 hours tomorrow then we’ll take tomorrow; if however you ask the same question but do the unpleasant task in 1 month for 5 hours or in 1 month 1 day for 5.5 hours we will pick the earlier one.
Defaults – people remain opted in to something when it is done at outset rather than if they have to choose. People will also contribute more when it is the default than if they are asked to choose.
Intuition – if a bat and ball cost £1.10 and the bat costs a £1 more than the ball, what does the ball cost?
Most people say 10p whereas the actual answer is 5p; if you got this wrong don’t worry – 50% of Princeton students asked this question also got it wrong.
Price – Australian course on social entrepreneurship offered for free had no subscribers. At £2500, it received over 20 subscribers, showing that people don’t always want the cheapest; they want to know that they are getting something of value. If you offer something for free are you actually saying it has NO value?
Framing – how we frame mathematical issues also has a major effect on how people will react. If you were having an operation and a doctor tells you that 90% of the people who have had it are still alive after 5 years, you are likely to feel much better than if the doctor tells you that out of every 100 people who have it 10 people die within 5 years.
Applying Behavioural Economics to your workplace
Firstly, don’t assume you know people as well as you should. The way we interact with others and the way we make decisions is complicated. Any manager of people should subscribe to a code that recognises this – for example:
- create healthy work place norms that are easy to subscribe to – a “positive default”
- don’t create value or reward systems that override positive, intrinsic motivations
- coach and performance manage individuals towards the company standards by understanding the heuristics that underpin their actions
- don’t spend time trying to override “cues” that have been ingrained over time and may actually be integral to an individuals success
- don’t take away appropriate rewards but make the routines that lead to them ‘healthier’
- embed understanding of behavioural economics. into internal communications and policy roll out to gain maximum buy-in
Secondly, processes that deliver service to clients should embed behavioural economics as a cornerstone:
- understand better how your clients minds work
- don’t assume that good behaviours have to be financially rewarded
- don’t build distribution strategies that exploit peoples inner biases
- be clearer about risks and rewards and challenge clients on the need to think for the longer term where relevant
- if you have “defaults”, make sure they are good for clients and not just convenient for your business