Who influences our financial decisions? What is the role of decision makers?

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27/6/2024

Posted by: Hawaz

This influence can be either negative or positive, resulting from the individual’s awareness or unconsciousness. Behavioral economics demonstrates that individuals are irrational in their decision-making process and are subject to numerous biases (psychological and external influences [1]). For example, the principle of bounded rationality [2] demonstrates that individuals have a limited capacity for thinking and analysis and are influenced by the availability of information and the way it is presented. A one-time decision (such as buying a family home) requires effort and familiarity with all the information and differs from recurring decisions (habits) in that they are recurring and do not require effort in making the decision.

Cognitive biases are multiple and vary from one individual to another based on many variables in financial decisions, for example. We are influenced by information that confirms or supports prior information we have, such as choosing to invest in one company’s stock over another, or preferring saving over investing because it is less risky (Conformation Bias)[3], or postponing saving in exchange for immediate consumption (Present Bias). Excessive confidence in our financial decisions can also affect our assessment of the risk of some investments (Overconfidence Bias)[4], thus achieving undesirable results in the long run.

Some decision-makers believe that providing information related to financial systems, programs, and services (such as savings, investment, etc.) through digital or traditional channels contributes to individuals’ understanding of the information and their decision-making based on it. However, many behavioral economics studies have shown that the mere availability of a large group of information does not guarantee that individuals will understand it and thus make sound financial decisions. The Behavioral Economics Unit in Britain conducted an experiment in cooperation with a government agency in which it focused on how information is presented, formulated, and its relationship to the beneficiaries’ understanding of the information and their ability to apply it in reality, in addition to measuring the extent of individuals’ trust in the entity providing the information, which is linked to the clarity of the information and the mechanism of its presentation. It became clear through the experiment that simplifying the presentation of information by adding graphics and illustrative figures with the inclusion of examples from daily life contributed to raising the percentage of understanding of the information and increasing the rate of trust in the entity providing the information to (19%) compared to the control sample [5].

So, how does behavioral economics or behavioral policy contribute to designing programs that help make sound financial decisions?

Behavioral economics encompasses numerous theories and studies on behavior change. It relies on selecting interventions based on a sample of the target group before implementing them on a wider scale. This saves cost, time, and effort, and helps understand their impact in a scientifically studied manner, before presenting them to decision-makers. Most behavior change tools and methodologies applied in behavioral economics are based on an understanding of these psychological biases (cognitive biases), such as the MIND [6] SPACE methodology. The application of these methodologies has also resulted in several key recommendations for designing behavioral interventions in the financial field, including:

Clarifying and simplifying financial information

The Behavioral Economics Unit in Australia conducted an experiment in which they changed the wording of household electricity bill information, including monthly consumption rates and the expected savings if consumption were reduced, and measured the impact on individuals’ confidence in the information and their decisions to change their plans. The results showed a 13% increase in confidence in the information [7].

Linking behavior to society

Social comparisons are used to illustrate the prevalence of behavior in society. One electricity company in Europe modified the wording of its electricity bill and compared the electricity consumption rate of a home with that of homes in the neighborhood. This resulted in a 2% reduction in electricity consumption. While this may seem small, it has a significant impact on reducing carbon dioxide emissions (more than 450,000 tons, equivalent to $75 million in energy savings [8]).

Choosing the right time to encourage savings

Timing is an important factor in changing behavior, such as saving at the beginning of the month when your monthly salary comes in, or spending unplanned things while shopping. One simulation focused on saving after completing a shopping spree. Several options were designed to allow shoppers to save the remainder of their budget even if they didn’t fully agree. The result was that 9 out of 10 people saved the remainder of their budget [9].

Providing incentives to encourage savings

Commitment programs can be activated to raise the savings rate, as they are a tool that encourages setting specific and binding goals, and may be linked to material or moral incentives if they are achieved, or fines and penalties if commitment is not met. Many savings programs provide incentives when committing to saving a specific amount of money [10].

Attention to ways of formulating information

In one experiment to understand how an investment portfolio is chosen, several types of high- and low-risk portfolios were presented. It was found that the investor is affected when potential losses are presented in dollars instead of percentages, regardless of his previous experience [11].

In the Kingdom of Saudi Arabia, there are some examples of programs and initiatives to stimulate savings and investment, in addition to government initiatives linked to Vision 2030 (such as the Financial Sector Development Program, which includes the cooperation of a number of government agencies to achieve targets in terms of systems, laws, and individual behaviors). Examples of government financial programs include the “Invest Wisely” platform launched by Tadawul, which includes a number of stages to cover the needs of various beneficiaries, starting with learning the basics of investment and its importance, then interaction through workshops and experts, and the actual application of the information learned through virtual trading, and finally competition between investors to encourage the practice of investment [12].

Therefore, it is possible to work on improving certain aspects of the individual’s decision-making process and directing it towards their actual needs by identifying the most important influences surrounding them and clearly presenting options. This enables decision-makers to motivate individuals to achieve their financial goals, create or improve programs, ensure resource utilization, and reduce costs by implementing studies that understand the decision-making mechanism.