I recently met a four-star general. He one of the most interesting people I’ve ever met, but instead of talking about himself he took a sincere interest in everyone around him. A self-described “econ-nerd”, he asked me many questions about my work helping people invest for retirement. I explained my frustration:
“You can describe risk to people in simple terms they understand, but they still don’t really get it. For example: You can ensure a particular income level in retirement, with high certainty, if you reduce risk. People say they want this certainty—except when the stock market goes up and they feel they missed out. They still don’t get that the upside of risk comes at a cost.”
The general nodded and said:
“It’s the same thing planning a military operation. You explain to the politician in charge that there’s an objective and ensuring its success will require the following resources. Or we can do it cheaper, but there’s a higher probability of things going wrong. They always go with the cheaper option and then get upset when things go wrong.”
What hope do we have to make good financial decisions if even the smartest people running our country—when there’s more at stake than money—don’t fully comprehend basic risk concepts either? Even when we are educated, behavioral economics explains why we still make bad choices.
Harvard economist David Laibson has studied why people don’t save enough and make poor investment choices. Often it’s not because we don’t know any better. He found many people often do not adequately value the future relative to today, lack self-control, make choices based on things are presented to them rather than their inherent quality, and procrastinate. Sometimes these behaviors reflect different values or preferences, so they are rational. Other times, they reflect a cognitive dissonance that leads people to make choices they’ll regret later.
Behavioral biases also impact how we invest: many investors exhibit over-confidence (thinking they can beat the market when few can), loss aversion (it hurts more to lose money than it does to gain it), disposition effect (people sell winners, but keep losers), under-diversify (hold too few stocks), and assume what happened in the past will happen again in the future. These factors explain why, even after I explained risk, people still expected high returns without giving up certainty.
Behavioral economics also explains why more financial education has not been more effective. It’s true many people don’t know the basics of finance. Research has found many Americans don’t understand concepts like compound interest and inflation. Financial illiteracy was a factor that caused the financial crisis. Households took on debt they couldn’t afford, in the years preceding the recession. Now excessive household debt can explain the lackluster recovery. It seems if people knew better, they’d make smarter choices and the economy would be more stable. So following the financial crisis, literacy programs have become more popular and received more funding. Several states have made financial education part of high school curriculum and the new Consumer Financial Protection Bureau has an office of financial education.
Financial literacy certainly can’t hurt, but even when we know better, behavioral biases trump our better judgment and good intentions. I once taught financial literacy to women living in a homeless shelter. I was struck by how complex the women’s’ financial lives were (mainly negotiating the government programs they lived on). The last thing they needed was an economics PhD to tell them they should save more; they already knew that. Nonetheless, once we looked into their budgets, there was more room to save than they realized. What prevented them from saving wasn’t lack of education, living in a shelter, or even a meager income; it was the same behavioral biases that haunt the rest of us: sometimes being impulsive, using crude financial rules, or not fully valuing the future relative to the present. The difference: the poor have much less room for error.
But this doesn’t mean we are all doomed for economic ruin. We may just need something more extreme than education. We can use what we know from behavioral economics and finance to elicit better decisions. When it comes to savings, people tend to be passive and procrastinate. That explains why automatically enrolling people into pension accounts increases participation. We can also default them into sensible investment choices that are cheap, well diversified and de-risk as they approach retirement. Behavioral biases may undermine our best efforts to educate people so they make good financial decisions, but we can use the same biases to induce people make better choices.