People often make errors when choosing and using financial products and can suffer considerable losses as a result. Using behavioural economics we can understand how these errors arise, why they persist, and what we can do to ameliorate them. Behavioural economics uses insights from psychology to explain why people behave the way they do. People do not always make choices in a rational and calculated way.

In fact, most human decision-making uses thought processes that are intuitive and automatic rather than deliberative and controlled.

Our preferences are influenced by emotions and psychological experiences.

  • Present bias – spending on a credit card for immediate gratification
  • Reference dependence and loss aversion – believing that insurance added on to a base product is cheap because the base price is much higher
  • Regret and other emotions – buying insurance for peace of mind

Rules of thumb can lead to incorrect beliefs.

  • Overconfidence – excessive belief in your ability to pick winning stocks
  • Over-extrapolation – extrapolating from just a few years of investment returns to the future
  • Projection bias – taking out a payday loan without considering payment difficulties that may arise in the future

We use decision-making short-cuts when assessing available information

  • Framing, salience and limited attention – overestimating the value of a packaged bank account because it is presented in a particularly attractive way
  • Mental accounting and narrow framing – investment decisions may be made asset-by-asset rather than considering the whole investment portfolio
  • Decision-making rules of thumb – investment may be split equally across all the funds in a pension scheme, rather than making a careful allocation decision
  • Persuasion and social influence – following financial advice just because an adviser is likeable

It is common sense that people will make mistakes when purchasing financial products and we know market forces themselves will not reduce these mistakes. That is why Regulators are increasingly focussing on financial advisers to be the ones who are required to be ‘the adult in the room’ when dealing with retail investors and in many cases, to help save people from themselves.