Chapter 6:

Household Finance
UMUR DURU THIENG P. THIRIN
ADVANCED READINGS IN ECONOMICS
2015-2016 - FALL

Outline
Introduction
The Human Decision Maker in Finance
Policies to Improve the Quality of
Household Financial Decisions
Conclusion

Introduction
1. Financial Decisions Uncertainty
2. Impulsive
judgments,
Emotions,
Temptation,
Loss
Aversion,
and
Procrastination
3. What- They want to do vs. What they
actually do
4. Complexity of the decision leads people
astray
5. Market Helps or Exacerbate them
6. Borrowers are nave and underestimate

Institutions & Poverty Effect

1. Limited institutional capacity and the safety nets to
safeguard individuals against financial losses
2. Poor people - more attentive to financial decisions
3. Poverty also heightens uncertainty about future costs
and benefits of different actions
4. The consequences of biases in financial decision
making can be profound for people in poverty, or on
the edge of poverty, because they lack a margin for
error.

The Human Decision Maker

in Finance
1. Are people
making?

rational

in

their

financial

decision

2. Losses Loom Larger Than Gains

3. Economically Suboptimal Choices
4. Loss Aversion and a Myopic Short-Term focus
5. Avoiding actually realizing losses, too eager to
realize gains

Welfare Losses
1. Pattern of holding on to losers
winners violates basic principles

and

selling

2. While gains signal potentially good investments,

losses signal poor ones.
3. Long Run Higher Returns Disposing of poor
investments and keeping the good ones.
4. to overvalue losses and undervalue gains can lead to
economically significant welfare losses

Present Bias: Overweighting the

Present
1. People have a tendency to frame financial decisions
in a narrow way, rather than considering their overall
financial situation
2. Current consumption needs loom larger than future
3. Unattractive details discourage people from savings
and investment (discouraged by timing costs)
4. Procrastinate and Postpone Decisions (losing Time)
5. Weighing one future payoff against another vs.
present one

Temptation
1. Is an extreme form of time inconsistency:
people may value some goods or payoffs
only at the moment of consumption (No
Future or Past)
2. Impatience Procrastinate Example
3. Behavior and decisions driven by
impatience, procrastination, and
temptation are economically relevant
4. Policies Obstacle Financial Decisions
(mandatory retirement contributions,
mandatory insurances)

Cognitive overload and

narrow framing
1. Limited attentional and mental resources
2. Decisions can be driven by emotional
impulses and a narrow short-term focus
3. Mentally tagged funds and savings

Financial Advices
1. Advice V.S Decision
2. Financial Advice Sufficient info or hidden
info
3. Conflicts of Interest Biased Advices
(commission)
4. Measurement of the clients risk tolerance
5. Clients often follow advice blindly
6. Careful regulation of financial advice
therefore seems warranted

Policies to improve the

quality of household
financial decisions

Framing choice effectively:

what is framing? "The termframe
dependencemeans that the way people behave
depends on the way that their decision
problems are framed. Shefrin (2000)

Frame A:

Frame B:

Framing choice effectively: A

study of payday borrow in USA.
1. Apayday loan(also called apayday advance,
salary loan, payroll loan, small dollar loan, short term
or cash advance loan) is a small, short-term
unsecured loan.
2. A study on payday borrowers in the United States,
for example, illustrates the effectiveness of framing
in an experiment where repayments were presented
either in dollar amounts or as interest rates (figure
6.1) (Bertrand and Morse 2011).
3. This very simple reframing of information
significantly discouraged costly repeat borrowing.

Framing choice effectively: A

study of payday borrow in USA.
(Cont.)

Changing the default

1. What is default? Infinance,defaultis failure to meet
thelegal conditions,for example when a home buyer
fails to make a mortgagepayment. (Wikipedia)
2. OR In psychology, thedefault optionis the option
the chooser will obtain if she does nothing.
3. Experiments and observational studies show that
making an option a default increases the likelihood
that it is chosen; this is called thedefault effect.

Changing the default (Cont.)

4. People often find it easier to make decisions that
require trade-offs between only future outcomes.
5. Choosing between different savings rates in the
future does not involve the short-term focus and
immediate financial consequences of decisions for
today.
6. A clever intervention uses these insights to have
people choose their own defaults for the future.

Changing the default (Cont.)

1. In this method, known as SMarT (Save More
Tomorrow), employees stipulate increases in savings
out of future pay raises (Thaler and Benartzi 2004;
Benartzi and Thaler 2013).
2. SMarT:
a. No current payoffs need to be considered
b. no reductions in disposable income are
experienced
c. future increases occur automatically, by default,
allowing savings to accumulate as long as the
person remains passive (figure 6.2).

Changing the default (Cont.)

Save More Tomorrow (SMarT)

Making microfinance more

effective
1. Abundant evidence indicates that access to financial
services for households with limited income is an
important factor in reducing poverty and inequality
(Karlan and Morduch 2010; World Bank 2008; Imai
and Azam 2012; Mullainathan and Shafir 2013).
2. microfinance institutions (MFIs) enable the poor to
smooth income shocks (see the review in Armendriz
and Morduch 2010).
3. Serving clients who have few assets, MFIs extend
noncollateralized loans to the poor, but with high
repayment rate.

Using nudges and reminders

1. What is Nudge? (nj)
Topushagainstgently,especiallyinordertogainatt
entionorgivea signal.
2. What is nudges theory? is flexible concept for:
a. understanding of how peoplethink,
makedecisions, andbehave,
b. helping peopleimprove
theirthinkinganddecisions.

Using nudges and reminders

(Cont.)
1. A research on behavioral finance is that simple
interventions such as social nudges and reminders,
can improve financial behavior.
2. One aspect of human behavior where reminders can
be particularly effective is overcoming lack of
attention.

Using nudges and reminders

(Cont.)
3. For instance, A series of experimental studies in
Bolivia, Peru, and the Philippines show that simple,
timely text messages reminding people to save
improve savings rates in line with earlier established
goals (Karlan, Morten, and Zinman 2012).
4. The studies find that reminders that emphasize a
specific goal, such as saving for a purchase of a
consumer durable like a television.
5. this finding suggests that individuals treat money
differently depending on the intended purpose and
are more likely to be willing to save for a specified
purchase than more generally.

Using nudges and reminders

(Cont.)
6. Likewise, reminders about late fees on loans have
been shown to significantly improve timely
repayment behaviors up to two years after the
reminder (Stango and Zinman 2011).
7. this highlights the potential role of simple and often
inexpensive nudges that can help improve financial
behaviors.
8. These nudges may even play on the behavioral
patterns and use them in smart ways.

Fighting temptation through

commitment
1. What is temptation? Temptationis a fundamental
desire to engage in short-term urges for enjoyment,
that threatens long-term goals. (Wikipedia)
2. Lack of self-control is a leading explanation for lack
of savings, and the absence of default savings plans
for most people in developing countries makes the
problem worse.

Figure 6.3 shows the expansion in the size of smallholder cash

crop farms as farmers gain access to commitment savings
devices in a randomized evaluation.
***"commitment" savings account, in which individuals restrict their right to
withdraw funds until they have reached a self-specified goal.

Simplifying and targeting

financial
education
1. Increasingly financial education programs are
becoming an integral part of development reform.
2. more recent research also tries to remove
psychological barriers to changing financial behavior
3. Simplifying ~ to keep it simple for household when
decide.
4. People are more likely to pay attention to financial
education if it is specifically targeted to their needs,
rather than provided in general terms.

Simplifying and targeting

financial
education (Cont.)
1. In a study of microfinance clients in India, when
researchers offered assistance in setting financial
goals and individualized financial counseling, they
found that both interventions led to significant
improvements in savings and budgeting behavior
(Carpena and others 2013).
2. In contrast, the study found that financial education
without the addition of either goal setting or
counseling had no impact on informal or formal
savings, opening bank accounts, or purchasing
financial products such as insurance.

A psychologically informed
understanding of decision making
can help policy makers improve
the match between intended and
actual effects of a financial policy
and can help individuals achieve
their financial goals.

Utilizing emotional persuasion

1. People often make important choices based on
emotions rather than on careful thought.
2. The most obvious example comes from the field of
advertising, which often relies on emotional appeals
to attract customers.
3. One of the most widespread and influential media for
conveying such messages is television.

A recent study in South Africa shows that television

programming can be harnessed to improve financial
decisions, as well (Berg and Zia 2013). gambleall
messages that were conveyed in the soap opera story
line (figure 6.4).

Shaping intertemporal
preferences at an
early age
1. Habits and preferences formed in early life tend to
stay with people into adulthood and can have
profound effects on how they make socioeconomic
decisions.
2. A compelling example is a long-term longitudinal
experiment conducted in the United States.
3. the children who exhibited more patience and selfcontrol achieved better educational and
socioeconomic outcomes (Mischel, Shoda, and
Rodriguez 1989).

Conclusion
1. This chapter presents key insights into the social and
behavioral influences on financial decision making.
2. It shows that the social psychology of advice make
financial decision making hard.

Conclusion (Cont.)
2. Policy interventions to address these tendencies
include:
a.
b.
c.
d.
e.
f.

changing default options,

using social networks in microfinance
employing nudges and reminders,
offering commitment devices
simplifying financial education, and
using emotional persuasion.

Todays weather is
cold, but Im
appreciated that
youre here.