Financial Education and Behavioral Finance: New Insights into the Role of Information in Financial Decisions

Transcription

1 Financial Education and Behavioral Finance: New Insights into the Role of Information in Financial Decisions María José Roa (CEMLA) IV Conference on Economic and Financial Education Paramaribo, Suriname, 6-7 December 2012

2 Motivation Two key assumptions have framed the traditional literature on financial markets: Individuals collect and use all of the available information in order to obtain maximum utility, well-being, and/or profit. Individuals have an unlimited capacity for processing information. These assumptions are based on the view that individuals have rational expectations.

3 Motivation Recent empirical evidence based on surveys and experimental activities within the fields of behavioral finance, financial crisis and financial education has offered economists new empirically based insights into how individuals use information in making financial decisions. The importance of information in financial decisions may be reduced or eliminated by psychological aspects of the individual.

4 Objective This research aims to complement the emerging body of literature by studying how individuals perceive and process information when making financial decisions. We review these contributions and suggest a number of broad guidelines that can provide a framework for future discussion of this topic within financial decision theory and financial education programs.

5 Outline Traditional Financial Economics Acquisition and Use of Information: Behavioral Economics Financial Education Behavioral Finance: Overconfidence, Financial Crisis and Trust Discussion and Conclusions

6 Traditional Financial Economics Information problems are seen as resulting from the complexity of saving and investment decisions. Agents must be able to predict several unknown variables, within increasingly intricate and uncertain financial and economic circumstances. Early work on financial economics: perfect information or simple rules of action (Fisher, Hicks, Kaldor).

7 The Rational Expectations Assumptions Rational expectations assumption: expectations are formed by taking into account all relevant available information about the economic variable (Muth, 1961). Unexpected changes, especially those produced by shifts in economic policy, may lead agents to make mistakes (not systematic). Lifecycle Models and Permanent Income Theory How to model? Probability distribution. Sophisticated mathematical tools, Econometric Models.

8 Psycological Aspects: Behavioral Economics Bounded Rationality (Simon, 1957) and shortcuts (Kahneman and Tversky, 1979): Cognitive Dissonance (Akerlof and Dickens, 1982; Feiler et a., 2006; Feiler, 2007) Illusion of Knowledge (Hall et al., 2007) and Confidence Effect (Eliaz and Schotter, 2007) Overconfidence: individual (Akerloff and Shiller, 2009) and collective (Benabou, 2009) Conformity of the Group (Asch, 1995) When we have to explain or justify our decisions, we tend to acquire more information than if we do not anticipate having to do so (Huber and Seiser, 2001).

9 Psycological Aspects People usually tend to respond better to specific and related information than to general statistical information (Nisbett et al. 1982; Sloan et al. 2003). Available Information is the most relevant. Events that are more easily investigated and recent are the most likely to occur. The tendency for individuals to rely more highly on information that is visually or emotionally more attractive. An anchor or initial starting point minimizes the amount of information and determines our final decision. Etc.

10 Financial Education The level of financial education throughout the world is very low, especially among the more vulnerable groups: those with very low levels of education or income (Lusardi, 2008; Hung et al., 2009). Lack of education and financial knowledge can lead individuals to fail to save enough for retirement, to overinvest in risky or overly safe assets, to retain costly mortgages rather than refinance them, to choose to remain outside of the formal financial sector completely, etc The last decade has seen the emergence of a wide variety of publicly funded programs created to provide financial and economic education to the general population (Lyons, 2005, 2010).

11 Financial Education There are many studies that show that financial education has improved the financial decision making of the agents. Chan and Stevens (2004), Mastrobuoni, (2009): greater knowledge of pension systems and Social Security positively affected retirement decisions. Staten et al. (2002): individuals who attended credit counseling programs for 3 years were able to reduce their debt and to improve their credit card handling. Hirad and Zorn, (2001): individuals who received credit counseling before buying their house had a smaller default rate than those who had not done so.

12 Financial Education Clark et al., (2006): financial education can produce significant changes in how individuals plan their retirement by improving understanding of financial topics or by providing more and better options, for example, new investment alternatives. Edmiston and Gillett-Fisher, (2006): introduced a theoretical model to explain the low rate of savings and excess of consumption in the US, and concluded that financial education led to optimal financial behavior. Hilgert et al. (2003): from the Survey of Consumers Finances documented the positive relationship between financial knowledge and financial behavior.

13 Financial Education The empirical evidence obtained from surveys and experimental works often show that individuals pay little attention to this information and that their capacity to process it is limited. Lusardi (2008): Most of the empirical literature on the effects of financial education programs did not demonstrate a positive result The financial decision-making process must be simplified, eg., by narrowing the number of options available (bounded rationality). The need to seek out more effective models for information transmission since, e.g., the information given in an isolated course does not seem to change financial behavior.

14 Financial Education De Meza et al., (2008): Financial education and training programs did little to encourage individuals to make better decisions regarding financial products. The financial behavior of individuals depends more on their psychological traits than on the information and skills they possess or on how they decide to use them. There are cognitive biases that seem to be relevant for financial decisionmaking. Easily digestible slogans that may influence behavior at key moments in the future. Personalized counseling would be more effective in producing positive change than methods that provide isolated information or passive education during a limited period of time.

15 Financial Education Iyengar et al., (2004) Lacko and Pappalardo (2004): an excess of information can render one unable to make financial decisions. Berheim et al., (2001): receive financial education over several years. Meier and Sprenger (2008): those who voluntarily decide to acquire financial education and information tend to share common psychological traits.

16 Financial Education The results of this growing body of literature seem quite contradictory and fairly inconclusive. Most authors point out that such apparently contradictory results are the product of (Lyons et al., 2006; Hung et al., 2009): Researchers studying this question disagree about how to define the success of a program or even how to define financial education. There are also enormous differences in the nature and rigor of existing empirical methodologies (Lusardi, 2004; Fox and Bartholomae, 2005; Lyons, 2005; Hogarth, 2006; Lyons et al., 2006; Lusardi and Mitchell, 2007, 2008).

17 Financial Education Lyons (2010): there is a consensus with regard to: Individual education programs are more effective than those targeted at groups. Individuals must be given the opportunity to gain experience by putting their lessons into practice. Other informational areas such as consumer protection policies or regulations are necessary to complement the education programs (Willis, 2008). Programs must not be overly ambitious and should instead encourage the consumer to make small changes in his financial behavior. Ongoing education, support and motivation are all necessary for a successful program.

18 Behavioral Finance: Overconfidence and Financial Crisis Financial crises are due to overconfidence within collectives and cognitive biases in individuals, which often lead these individuals to overinvest in risky assets despite contrary market signals based on real, available, clear information (Benabou, 2009). Thaler and Sunstein (2008) One cause of the subprime mortgages disaster was that most of those holding the mortgages did not understand the conditions of the loans. High-level executives of investment groups did not know how complex and ambiguous there own financial instruments are. The 90 s stock market bubble was explained as the result of social contagion.

19 Behavioral Finance: Overconfidence and Financial Crisis Akerlof and Shiller (2009): Confidence is a matter of faith, which often leads individuals to reject some information relevant to their financial decisionmaking. They may even process such information, but in the end, they will act in accordance with what they believe is true. Identify confidence with the Keynesian animal spirits and argue that these patterns of wider beliefs underlie the distinct phases of a financial boom or crisis. They lead individuals to make non-optimal investment, savings and consumer decisions, contaminating each other through what the authors call the confidence multiplier, it can produce waves of overconfidence or pessimism among individuals.

20 Behavioral Finance: Overconfidence and Financial Crisis Wong and Quesada (2009): Discuss some examples from experimental economics and psychology in order to explain a number of recent trends: the lack of future planning and the resulting low savings rate, the current financial crisis, and the excesses of consumption and investment in the developing world. The need to incorporate the excesses of optimism and confidence, monetary illusion, different sensitivity to earnings and losses, temporary inconsistency plans, bounded rationality, cognitive dissonance, and illusion of knowledge.

21 Behavioral Finance: Trust and Financial Decisions Giné et al., (2006); Di Giannatale, Elbittar and Roa (2009, 2011): Financial transactions are related to the levels of trust and association among individuals. The existence of trust sometimes seems to reduce or eliminate individuals use of available information in financial decisionmaking. Individuals seemed interested in acquiring information but they did not then use the information they purchased in making their financial decisions.

22 Behavioral Finance: Trust and Financial Decisions Duflo and Saez (2004), Lusardi and Mitchell (2007), Lusardi (2008): Most individuals, especially those having a low income and little education, do not seek help from a financial counselor but from family and friends. The reason individuals fail to take professional advice into account has nothing to do with its availability. They would take the professional advice into account if it supported their own ideas.

23 Discussion and Conclusions Although viewed from different perspectives, the works in both the behavioral finance and financial-education literatures reach the same conclusion: that there are various important psychological aspects that determine individuals behavior regarding the use and acquisition of information. Some aspects seem to play a dominant role in financial decisionmaking: overconfidence, trust and limited cognitive capabilities (Simon, Hayek, Keynes). The results from these literatures do not discredit the internal rigor of the theories regarding traditional financial markets: expansion o generalization of the traditional theoretical frameworks for financial decision-making.

24 Discussion and Conclusions Overconfidence and limited cognitive capabilities could be combined within a model of financial decision-making. Limited capacity would be considered an ad hoc assumption, based on psychological works Formalize individual or group overconfidence as variables that can determine the financial behavior of individuals: Exogenous: stochastic variable, such as a sunspot variable that reflects the Keynesians animal spirits (Cass and Shell, 1983). Endogenous: rely on aspects that feed overconfidence, like news reports, or on a feeling of belonging to a company or nation (Benabou, 2009).

25 Discussion and Conclusions This research is relevant to the extent that it brings a better understanding of how individuals make financial decisions. Design programs such as financial education programs in order to promote financial inclusion and encourage people to make better financial decisions, in developing and developed economies. Since human behavior is influenced by psychological elements, as well as by anthropological, cultural, historical and social elements, the results obtained in the theoretical and empirical works should not be generalized (Cassar and Wydick, 2010).

26 Financial Education and Behavioral Finance: New Insights into the Role of Information in Financial Decisions Available at:

27 Thank you Gracias