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The Future of Financial Services: Using Behavioral Science to Help Consumers Form Good Habits

The Next Big Evolution in Finance Will Rely on Psychology, Not Technology (Part 1)

The current crisis is highlighting a fact that we’ve known for quite some time – many people are not financially healthy. Consumer debt in the U.S. reached an all-time high at $14.1 trillion in 2019, according to an annual Experian Consumer Debt Study. The COVID-19 pandemic and resulting economic downturn has certainly exacerbated this issue in the short- to medium-term (and potentially beyond). However, it also illustrates an intriguing long-term opportunity: consumers will need (and want to work with) banks that are able to help them achieve better financial health.

A main obstacle, of course, is that financial health – like any other dimension of health – requires a level of discipline that is quite rare. This is in part why the first generation of personal financial management tools, like Mint.com, failed. Customers had to do too much work in order to improve their financial well-being. People were often unable to sustain a commitment to that level of work despite a sincere desire to be financially healthier. This contradiction in human nature is the root of the problem.

How are banks and lenders going to override consumers’ psychological biases so they can help people improve their financial health? To do this, we need to understand the (behavioral) science behind what motivates individuals and how these concepts can be applied to financial services.

What Drives People? Behavioral Science & Human Action

In a “perfect” world, humans would make optimal decisions based on a prudent weighing of costs and benefits. This economic theory assumes that individuals are consistently rational and will always act in their own best interests, despite emotions or external factors. For the real world though, behavioral science explains that people are not rational and are often terrible at making good decisions.

Behavioral science ignores the traditional economic models and seeks to understand the contradictory, irrational behaviors of humans. More specialized fields within behavioral science include behavioral economics and behavioral finance. These are particularly valuable areas of research, considering how many of the straightforward tactics for personal financial management have clearly failed us.

Simply presenting consumers with the available options doesn’t guarantee optimal outcomes because, in many cases, we cannot rely on people to make choices that will benefit their long-term (or even short-term) well-being. On a primal level, the immediacy of danger or reward drives most human response behavior. If the danger or negative result isn’t immediate, we have a tendency to discount it, which is why goals pertaining to financial health (as well as physical fitness) are difficult for people to achieve – because the consequences of paying with a credit card or eating a sugar-laden snack are delayed.

While the pain of paying (a concept coined by Ofer Zellermayer in 1996) is somewhat diminished by credit card purchases, research has shown that most of us are loss-adverse and do experience the sting of spending money, albeit some more than others. When it comes to decision-making, our willingness to take certain risks depends on the context and the way our choices are framed. Prospect theory (introduced by Amos Tversky and Daniel Kahneman in 1979) is the founding premise for behavioral economics and behavioral finance; it describes how individuals respond differently when their choices are presented as a gain versus a loss. Consider this decision problem:

  1. Which of the following would you prefer?
  2. A certain win of $300, or
  3. A 30% chance to win $1,000 (and a 70% chance to win nothing)
  4. And which of these would you prefer?
  5. A certain loss of $700, or
  6. A 70% chance to lose $1,000 (and a 30% chance to lose nothing)

When faced with the first problem, most people select the riskless option A, indicating risk-adverse behavior. For the second problem, most people choose the riskier option D, indicating risk-seeking (loss-adverse) behavior. This asymmetrical behavior illustrates how we make decisions in relative terms, as opposed to absolute terms, based on the potential gains or losses corresponding to the particular circumstances. It also demonstrates that most of us dislike a loss more than we like an equivalent gain.

The Psychology of Financial Capability

Financial health requires discipline – that’s the core problem, and digitizing it doesn’t help. Information alone isn’t enough to prompt good decisions or changes to one’s habits. We know well enough that people often do things that go against their own self-interests.

Even when people have easy access to good information, we may choose not to seek it out in an effort to avoid the negative (often psychological) repercussions of knowing that information. For example, an investor is less likely to check their portfolio when the stock market is down. This type of information avoidance, labeled the ostrich effect (Karlsson et al., 2009), tends to carry negative utility in the long-term because it deprives people of knowledge that can help them improve their financial future.

Banks and lenders must address these unconscious behavioral challenges that impede financial health so they can try to move consumers in directions that will improve their lives and create mutually healthy outcomes. We should be looking to behavioral science and how applying these concepts to financial services can help people form better habits.

David Lightfoot is vice president of product management and heads up FICO’s customer lifecycle management area, which includes solutions for originations, customer management, and collections and recovery.

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