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Behavioral Finance and Self-control


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8. mail 2019 toimus Eesti Pangas avatud seminar, kus Tilburgi ülikooli majanduspsühholoogia professor Fred van Raaij tutvustas uurimust teemal „Behavioral finance and self-control“. Käitumusliku rahanduse valdkonda kuuluvas ettekandes räägitakse tarbijate, ettevõtjate ja investorite käitumise psühholoogilisest ja sotsioloogilisest vaatenurgast.

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Behavioral Finance and Self-control

  1. 1. Behavioral FinanceBehavioral Finance and Self-controland Self-control W. Fred van Raaij,W. Fred van Raaij, Tilburg University, The NetherlandsTilburg University, The Netherlands Tallinn, Estonia: Eesti Pank, May 8, 2019Tallinn, Estonia: Eesti Pank, May 8, 2019
  2. 2. Behavioral financeBehavioral finance Behavioral finance is studying financial behavior (of consumers, entrepreneurs, investors) from a psychological and/or sociological perspective, including emotions, cognitive shortcomings, social influences, deviating from an economic model of maximizing or optimizing objective or subjective utility. If these deviations are systematic, financial behaviour can be explained and predicted (Ariely: predictive irrationality). In a similar way, health and educational behaviour can be studied.
  3. 3. Self-controlSelf-control Self-control is resisting internal and external short-term temptations and being persistent in order to reach long-term goals. Internal temptations are ideas, thoughts, impulses becoming conscious in the brain. External temptations are attractive objects, situations and messages to be followed for immediate gratification. Self-control can be exerted through internal and external mechanisms. Self-control may have a: prevention focus to avoid temptations and mistakes. promotion focus to reach desirable outcomes.
  4. 4. Free will?Free will? Experiments by Kornhuber & Deecke (1965) and Benjamin Libet (1985, 1989). Freely voluntary motor acts (such as a flexion of the wrist) are preceded by a specific electrical change in the brain (readiness potential, RP) 550 ms before the act. Humans become aware of the intention to act 350-400 ms after the RP. This is 150-200 ms before the motor act. The volitional process is thus initiated unconsciously. Does free will exist? An important philosophical and theological question. This affects views on determinism (“we are our brain”), personal responsibility, and guilt. ““Mind → brain” or “brain → mind”?Mind → brain” or “brain → mind”?
  5. 5. Free will?Free will? Experiments by Kornhuber & Deecke (1965) and Benjamin Libet (1985, 1989). Readiness potential (RP I): -1020 ms. Readiness potential (RP II2): -530 ms. Wish to move (W): -200 ms. S: report of act (50 ms before the act). Electromyogram (EMG): act.
  6. 6. Free will?Free will? Experiments by Kornhuber & Deecke (1965) and Benjamin Libet (1985, 1989).
  7. 7. Free will?Free will? We are unaware of 90-95% of our brain activities, for instance the regulation of blood circulation, breathing, digestion of food, homeostasis and movement. Only in dangerous situations or disturbances of these processes, we become aware of them (alarm). Many observations, impulses, emotions, ideas and intentions remain nonconscious. Only a few become strong enough to become aware of them (mind). With awareness we can control the outcome; we can accept or reject the conscious idea. Free will does not initiate a voluntary act, but we can accept/reject (control) the performance of the act.
  8. 8. Three effects of internal stimulationThree effects of internal stimulation A became conscious and is consciously further developed. B became conscious and is rejected/veto-ed. C remains nonconscious and may influence behaviour through priming. Priming is increasing the salience of some ideas or behaviours at the nonconscious level, and this may influence choice and movement. An earlier task/behaviour may thus affect a later unrelated task/behaviour. AA BB CC X conscious level nonconscious level Self-control
  9. 9. Systems 1 and 2Systems 1 and 2 Robert Zajonc: mere-exposure experiments (1968), in which repeated exposure to external stimuli (Chinese characters) without recognition leads to ‘liking’. Zajonc (1984) concludes the ‘primacy of affect’, an independent emotional process. Primary affective reaction (Van Raaij 1984, 1989) as a first reaction to stimuli before a cognitive reaction. The emotional process is (neurologically) faster than the cognitive process. Daniel Kahneman (Nobel prize lecture, 2003; 2011): System 1 (nonconscious, fast, intuitive; less/no free will) and System 2 (conscious, slow, deliberate; free will). The existence of two separate and independent systems is rather unlikely. Both systems have functional specialisations and there are interactions between both systems. Several levels of consciousness exist (Van Raaij & Ye 2005). Robert Zajonc 1923-2008 Daniel Kahneman b. 1934
  10. 10. Nonconscious and conscious systemNonconscious and conscious system System 1, nonconsciousSystem 1, nonconscious System 2, consciousSystem 2, conscious •Early in evolutionEarly in evolution •AutomaticAutomatic •Online pattern recognitionOnline pattern recognition •Here and nowHere and now •Fast, ‘effortless’Fast, ‘effortless’ •Non-intentionalNon-intentional •Parallel processesParallel processes •Multiple systemsMultiple systems •Many tasks at the same timeMany tasks at the same time •‘‘No capacity constraints’No capacity constraints’ •RigidRigid •Sensitive to negative informationSensitive to negative information •Late in evolutionLate in evolution •Deliberate, controlledDeliberate, controlled •Checks & balances afterwardsChecks & balances afterwards •Long termLong term •Slow, effortfulSlow, effortful •IntentionalIntentional •Serial processesSerial processes •Single systemSingle system •One task at a timeOne task at a time •Capacity constraintsCapacity constraints •FlexibleFlexible •Sensitive to positive informationSensitive to positive information
  11. 11. Nonconscious and conscious levelsNonconscious and conscious levels Not strong enough for awareness: Priming. Effect on saliency. Not strong enough for awareness: Priming. Effect on saliency. Primary affective reaction. Fast, automatic reaction. like/dislike, bias. Primary affective reaction. Fast, automatic reaction. like/dislike, bias. Strong enough for awareness: accept/reject (Illusion of) self-control. Strong enough for awareness: accept/reject (Illusion of) self-control. Cognitive reaction. Rationalization. accept/reject (Illusion of) self-control. Cognitive reaction. Rationalization. accept/reject (Illusion of) self-control. Internal stimulation External stimulation Nonconscious Conscious System 1System 1 System 2System 2
  12. 12. NumericalNumerical primingpriming 11 Numerical priming (Ekkehard Stephan, 2005) in a study for the Süddeutsche Klassenloterie: 1. In a telephone conversation, people were asked whether a lottery ticket of the Süddeutsche Klassenloterie is cheaper or more expensive than € 30 (in the other condition: € 60). 2. Then the price of a lottery ticket was mentioned: € 45. 3. The willingness to buy a lottery ticket was higher in the € 60 condition than in the € 30 condition. An explanation is the order of the prices. The price of € 45 is more attractive/ acceptable, after a higher price has been mentioned. Ekkehard Stephan
  13. 13. Numerical primingNumerical priming 22 Unconscious activation of a scheme/mindset of a low vs. high price. After activation of a high price, the lower price will be perceived as a gain. The result is a higher willingness to pay (WTP) than when first a lower price has been activated. The price is a relevant prime. Even an irrelevant prime (‘You are the 87th/7th person we call today’, thus an irrelevant high/low number), activates a scheme/mindset of high/low prices and thus a higher/lower WTP (willingness to buy a lottery ticket). Ekkehard Stephan
  14. 14. Internal self-controlInternal self-control Internal self-control is often a dual-motive conflict between an easy response (short- term benefits, temptation; System 1) and an effortful deliberate decision process (long-term benefits; System 2). How to improve self-control?  Associate the temptation with a loss and a negative label.  Reconstruct the temptation in an abstract way (Moore et al 1976). An abstract mindset facilitates self-control.  Implementation intentions (Gollwitzer 1999). “In situation X, I will do Y.”  Mental budgeting (De Groot & Van Raaij 2016).  If your willpower and persistence are weak, try to externalize self-control.
  15. 15. External self-control by personExternal self-control by person External self-control is a temporary restriction of personal freedom with a contract or regulation in order to reach a long-term goal. External self-control may be initiated by the person him/herself:  Avoid contact with the temptation.  Block effect of temptation: Odysseus and the Sirens.  Automatic (pension) saving, Christmas club.  Cut-off rule with investments.  Automatic donations to charities.  Keep regular and windfall income separate.  Keep disposable income and consumption low.  Contract with partner to stop smoking / drinking / gambling (social control).
  16. 16. External control by policy makerExternal control by policy maker External control is a specific design of the environment in order to influence behaviour, for the (assumed) benefit of persons being nudged (libertarian paternalism). External control may be initiated by an outside organisation (policy maker, marketer).  Nudge, decision architecture.  Defaults, opt-out (pension plan; donor system).  Prompts, reminders.  Attraction effect.  Priming.
  17. 17. Attraction effectAttraction effect 11 The magazine The Economist offers three options for an annual subscription: A. Online subscription for € 45. B. Subscription print version for € 90. C. Subsciption print + online version for € 90. Which option do you prefer? In a sample, 16% chooses option A and 84% chooses option C. No one chooses option B (C > B; C dominates B). If option B is deleted, 68% chooses option A and 32% chooses option C (preference reversal). Deleting option B (a non-selected option) changes the choice between A and C. Option B is a decoy option, present to make option C more attractive. This is a presentation bias, often present in the assortment of catalogs and supermarkets. A. 16% 68% B. 0% C. 84% 32%
  18. 18. Attraction effectAttraction effect 22 A B Price € 40 € 30 Coverage high low A B C Price € 40 € 30 € 40 Coverage high low medium A B D Price € 40 € 30 € 30 Coverage high low very low Assortment of insurances A and B. We add insurance C. Which insurance becomes more attractive? We add insurance D. Which insurance becomes more attractive? Addition of asymmetrically dominated alternatives.
  19. 19. Self-control of financial behaviorSelf-control of financial behavior Internal control Financial behavior Money management Financial decision making Purchasing Behavioral outcomes Environmental control Pre- commitment devices Decision architecture: structure, comparison, defaults, nudging Social control Requested social support/control Social reference/ influence Feedback to upstream Self-regulation Dual-motive conflict Mental budgetting
  20. 20. Co-holding puzzlesCo-holding puzzles Co-holding puzzles: 1. Credit and savings (Gathergood & Weber 2014). 2. Car finance (loan) and savings. 3. Credit-card debt and liquid, retirement assets (Bertaut et al 2008). Explanations Mistake, lack of financial literacy. Preference for holding a liquid financial buffer for emergencies. Expected lack of willpower to restore savings. Pre-commitment to paying off credit-card debt, loan/credit. Control impulsive spending. Self-control
  21. 21. Prospect theoryProspect theory Fourfold pattern (Kahneman & Tversky) A. 95% chance of winning € 10,000 or sure gain of € 9,500 “bird in hand” A. 95% chance of winning € 10,000 or sure gain of € 9,500 “bird in hand” B. 95% chance of losing € 10,000 or sure loss of € 9,500 “gambling” B. 95% chance of losing € 10,000 or sure loss of € 9,500 “gambling” C. 5% chance of winning € 10,000 or sure gain of € 500 “lottery ticket” C. 5% chance of winning € 10,000 or sure gain of € 500 “lottery ticket” D. 5% chance of losing € 10,000 or sure loss of € 500 “insurance premium” D. 5% chance of losing € 10,000 or sure loss of € 500 “insurance premium” winning losing risk aversionrisk seeking 95% 5%
  22. 22. S-shaped value function of prospect theoryS-shaped value function of prospect theory gains losses positive value negative value 0 20 -20 100 -150 125 40 -40 -200 Gains and losses in relation to reference point. Value of loss is 1.5 to 2 times larger than the value of gain (in absolute terms). Loss aversion is stronger
  23. 23. Prospect theoryProspect theory Prospect theory (Kahneman & Tversky 1979): 1. Convex function in quadrant 1: diminishing marginal gains. 2. Concave function in quadrant 3: diminishing marginal losses. 3. Gains and losses are evaluated from a reference point (0). 4. Reference points are updated over time. 5. Losses loom larger than gains. A loss creates a larger negative value than a gain creates a positive value.
  24. 24. Paying off debtPaying off debt Suppose, a debtor has two credit-card debts to pay off (Amar 2011). Paying off the small debt of card A removes more negative value than paying off a part of the large debt of card B, if these credit cards are treated separately, even if card B has a higher interest rate. Card A: paying off a debt of 20, removes 150 units of negative value. Card B: paying off a debt of 40 down to 20, removes 50 units of negative value. credit -40 -20 -150 -200 negative value 0 Quadrant 3 Possible solution: repartition total debt into equal parts of 20 units, and pay off the part with highest interest rate first.
  25. 25. Framing, prospect theoryFraming, prospect theory 11 Suppose Estonia prepares for the Asian flu that probably will take the lives of 600 people. There are two inoculation programs (A and B) available: A. 200 out of 600 people will be saved. B. A probability of 1/3 that all 600 people will be saved, and a probability of 2/3 that nobody will be saved. Which program do you select, A or B? There are two other inoculation programs (C and D) available: C. 400 out of 600 people will die. D. A probability of 1/3 that nobody will die, and a probability of 2/3 that all 600 people will die. Which program do you select, C of D?
  26. 26. Framing, prospect theoryFraming, prospect theory 22 A. 200 of 600 people will be saved. B. A probability of 1/3 that all 600 people will be saved, and a probability of 2/3 that nobody will be saved. Most frequent answer: A C. 400 of 600 people will die. D. A probability of 1/3 that nobody will die, and a probability of 2/3 that all 600 people will die. Most frequent answer: D Note that A and C are identical: 200 people will be saved. And B and D are identical: 0 or 600 people will be saved. Positive/negative framing. Preference reversal? Losses loom larger than gains.
  27. 27. SMarT programSMarT program Thaler & Benartzi (2004): “Save More Tomorrow.” How to get people to start pension saving? •Loss aversion: saving may be seen as a loss (less spending). •Procrastination: inertia, delaying to start saving. •Present-time orientation: later pay-offs have a lower value than present pay-offs. How to circumvent these inhibiting factors? 1.Get the consent to opt-in a pension saving program (procrastination, default option). 2.Start saving at a later moment in time (hyperbolic discounting). 3.Start saving at a pay-raise (loss aversion). 4.Increase saving at next pay-raise. 5.Opt-out is possible, but is not the default.
  28. 28. SMarT programSMarT program Thaler & Benartzi (2004): Save More Tomorrow. How to get people to start pension saving? •Loss aversion: saving may be seen as a loss (less spending). •Procrastination: inertia, delaying to start saving. •Present-time orientation: later pay-offs have a lower value than present pay-offs. How to circumvent these inhibiting factors? 1.Get the consent to opt-in a pension saving program (procrastination, default option). 2.Start saving at a later moment in time (hyperbolic discounting). 3.Start saving at a pay-raise (loss aversion). 4.Increase saving at the next pay-raise. 5.Opt-out is possible, but is not the default.
  29. 29. Time preferenceTime preference Discounted utility model of Samuelson (1937) as an explanation of discounting future income (with a constant discount factor). How much compensation do you accept (WTA) to receive an amount of € 15 a month, a year, or 10 years later? Receiving an amount later is conceived as a loss. The WTAs are higher than interest + inflation, and can be best fitted by a hyperbole: hyperbolic discounting. The WTA becomes more realistic with a longer time interval. € 15 A month later A year later 10 Years later Compensation € 20 € 50 € 100 Discount factor 345% 120% 19% hyperbolic exponential
  30. 30. Reference points in timeReference points in time How much you want to accept (WTA) to receive an amount later? How much are you willing to pay (WTP) to receive an amount earlier? (Loewenstein, 1988, Table 3). WTA > WTP. More compensation desired (WTA) for a delay than people are willing to pay (WTP) for an equal (same duration) speed-up (delay/speed-up asymmetry). How can this be explained by prospect theory? Delay is a loss. Speed-up is a gain. More compensation required for a loss. Delay (WTA, receive later) Speed-up (WTP, receive earlier) Sign. 1 versus 4 weeks $ 1.09 $ 0.25 .001 4 versus 8 weeks $ 0.84 $ 0.37 .005 1 versus 8 weeks $ 1.76 $ 0.52 .001
  31. 31. Constant and hyperbolic discountingConstant and hyperbolic discounting Present-time versus future-time orientation.
  32. 32. Lump sum or annuity?Lump sum or annuity? Choice between a lump sum or an annuity as a pension. An annuity includes a life insurance and guarantees a monthly income up to death. Relevant aspects are:  Present-time orientation.  People overestimate what can be done with a lump sum, especially if they are not accustomed to large amounts of money.  People underestimate the real costs of an annuitized pension plan.  People underestimate the value of life insurance. Bütler & Teppa (2007): majority selects annuity; Swiss administrative data. Brown (2007): aversion to annuities. Cronqvist & Thaler (2004): design choice; portfolio actively chosen < default; Swedish data.
  33. 33. ProcrastinationProcrastination Procrastination: Starting too late with a task and running the risk of not completing the task on time. For instance, studying for an exam, or starting too late with pension saving. This is often an internal self-control issue. What are the reasons of procrastination? 1. Task is unattractive. 2. Task is very important and needs careful attention. 3. Smaller tasks go first. 4. It is uncertain how much time the task will take. 5. Task is perceived in an abstract mindset. If the task is seen in a concrete mindset, it is more clear what has to be done.
  34. 34. ProcrastinationProcrastination Reasons for procrastination are: 1. Small and attractive tasks get priority. 2. Task aversiveness; unattractive task. 3. Task difficulty; task requires effort and mental resources. 4. Task importance; task should be done carefully. 5. Size of the task; many hours or many days to complete the task. 6. Task uncertainty; uncertain how long it will take to finish the task.  Procrastination may lead to poor performance: stress, mistakes.  Procrastination may lead to better performance (arousal).  Procrastination improves mood in the short term.  Delaying attractive tasks is a sign of self-control. Recommendations: De-emphasize importance of the task. Partition the task in a sequence of (small) parts/steps. Facilitate starting the task (SMarT) (Zeigarnik effect).
  35. 35. PartitioningPartitioning Dividing a ‘big’ task into smaller subtasks: • Saving. • Paying off loans. • Stepwise procedures for entering a pension plan. • Stepwise procedures for purchasing on the internet. Saving or paying off € 3000 a year looks like an insurmountable task, but € 60 a week is a manageable task. Not taking a ‘latte’ of € 4,90 at Starbucks is an insignificant contribution to saving € 3000 a year, but is a realistic contribution to saving € 60 a week. 0,16% versus 8,2%.
  36. 36. In economic theory, it is often assumed that people make decisions using one comprehensive, wealth-based account. Mental accounting/budgetting is the set of cognitive operations used by individuals to organize, budget, evaluate and keep track of their expenses, in order not to overspend (preventive goal), usually not about exact spending but about estimates of spending (De Groot & Van Raaij 2016). People may divide their monthly income into several ‘accounts’ (rent, school, groceries, clothing, restaurants, etc.) to keep track of their expenses. An account constitutes of the expenses in a specific category or domain. 1. Set a mental budget for each account. 2. If the budget has been spent, stop spending on this account in this period. 3. If the budget has been spent, postpone spending to the next period. 4. If the budget has been overspent, reduce spending in the next period. 5. If needed, adapt the budget for an account. Mental AccountingMental Accounting
  37. 37. Types of biases/heuristicsTypes of biases/heuristics Biases and heuristics in behavioral economics: Mistakes, shortcomings: conjunction fallacy, planning fallacy, availability bias, representativeness bias. Debiasing? Subconscious effects: attraction effect, numerical priming, framing. Default: opt-in versus opt-out, SMaRT. Loss aversion: ‘free’ bias, endowment effect, SMarT, framing. Self-control: co-holding debt-savings, procrastination, SMarT. Time orientation: hyperbolic discounting, SMarT. Which elements should be included in a new theory of behavioral economics?  Gain versus loss.  Promotion versus prevention.  Present versus future.  Concrete versus abstract mindset.  Self-control.
  38. 38. ReferencesReferences Dan Ariely. Predictably Irrational. London: HarperCollins, 2009 (revised and expanded edition). Dan Ariely. The Upside of Irrationality. London: HarperCollins, 2010. Daniel Kahneman. Thinking, Fast and Slow. New York: Farrar, Straus & Giroux, 2011. George F. Loewenstein. Frames of mind in intertemporal choice. Management Science, 34(2), 1988, 200-214. Richard Thaler. The Winner’s Curse. Paradoxes and Anomalies of Economic Life. Princeton: Princeton University Press, 1992. Richard H. Thaler & Cass Sunstein. Nudge: Improving Decisions about Health, Wealth, and Happiness. New Haven, CT: Yale University Press, 2008. Richard H. Thaler. Misbehaving. New York: W.W. Norton, 2015. W. Fred van Raaij. Understanding Consumer Financial Behavior. Money Management in an Age of Financial Illiteracy. New York: Palgrave Macmillan, 2016.
  39. 39. Understanding Consumer FinancialUnderstanding Consumer Financial BehaviorBehavior Understanding Consumer Financial Behavior in an Age of Financial Illiteracy New York: Palgrave Macmillan, 2016. ISBN: 978 11 37 54424 7.
  40. 40. ‘‘Free’ biasFree’ bias In an experiment by Shampanier, Mazar & Ariely (2007) two types of chocolate were offered (Lindt truffels and Hershey kisses) for the following prices: Lindt truffel , 15 ctLindt truffel , 15 ct 73%73% Hershey kiss, 1 ctHershey kiss, 1 ct 27%27% Lindt truffel, 14 ctLindt truffel, 14 ct 31%31% Hershey kiss, freeHershey kiss, free 69%69% ‘Free’ has no downside. There is no trade-off between utility/preference and price. There is no ‘loss’, no payment aversion. ‘Free’ is obviously always possible without any risk or consequence. This is another example of preference reversal. ‘Third product free’ is more attractive than ’33% discount’. Choosing between a free voucher of € 10 or a voucher of € 20 for the price of € 7, most people choose the free voucher. Why? People may not be sure to use the voucher in the future.
  41. 41. Endowment effectEndowment effect 11 Thaler (1980): Removing a good from one’s endowment/possession (loss) is more painful than that adding the same good (gain) to one’s endowment is pleasant. Consequently, goods that are included in the endowment will be more highly valued than those not in endowment. WTA > WTP. The willingness to accept (WTA, compensation) to give up an item in possession is higher than the willingness to pay (WTP) to obtain the same item. Ratios vary from 2:1 to 6:1. •WTA: minimum amount willing to accept a loss (sell). •WTP: maximum amount willing to pay for a gain (buy). Few transactions between sellers and buyers.
  42. 42. Endowment effectEndowment effect 22 Knetsch (1989): Product evaluation of three groups: 1.Received a coffee mug. 2.Received a chocolate bar. 3.Received nothing. WTA > WTP. Preference depends on current ownership. Keep your belongings. Low willingness to trade (10/11%). Explanation of endowment effect: 1. Loss aversion; high WTA. 2. Owners/sellers a have different mindset than buyers. 3. Evolutionary explanation: A loss has more severe implications than a gain.. Group Preference (%) 1. 89 11 2. 10 90 3. No product 56 44
  43. 43. Endowment effectEndowment effect 33 Knetsch & Sinden (1984): Lottery tickets more highly valued by owners than by non-owners. Explanations: loss aversion, anticipated regret. Endowment effect for goods (coffee mugs, chocolate bars), tokens (lottery tickets), goods for resale?, services?, money? Lottery tickets Yes No WTP: buying for $ 2 50% 50% WTA: selling for $ 2 24% 76%
  44. 44. Psychological distancePsychological distance Construal-level theory (Trope & Liberman 2010): Psychological distance from a personal reference point: proximal (now, here, self, fact) versus distant (future, there, others, fiction). Proximal has concrete and observable specific characteristics; direct experience. Distant has abstract and general characteristics; must be inferred or imagined.
  45. 45. Psychological distancePsychological distance Proximal Concrete mindset Observable Less self-control Distant Abstract mindset Unobservable More self-control Space Here There Time Present (now) Past (then): memory. Future (then): expectation, prediction. Social distance Self Other Hypotheticality Fact Fiction: speculate about about what might have been.
  46. 46. Mindsets at three levelsMindsets at three levels B. Planning mindset Planning (tax) obligations. Starting on time. Keeping enough liquidity. C. Abstract mindset Values. Personality. Generalized characteristics. A. Concrete mindset Paying bills. Downloading a file. Filling out a form. How? How? Why? Why? What?What? Repetition of behaviour Repetition of behaviour Generalisation of behaviour Generalisation of behaviour abstract concrete