No 2009/7: Psychology, Financial Decision Making, and Financial Crises

Abstract: It is understandable in times of financial crisis that the general public asks how this could happen. And since the market actors appear so irrational, it is also understandable that people – lay people and experts alike – believe that “psychological” factors play a decisive role. Is there evidence for this and what is the evidence? It is true that in general people individually use their cognitive and other resources in sensible ways, and that they collectively have developed institutions that effectively regulate economic and other transactions. It is likewise true that extreme circumstances sometimes are beyond people´s capacity, individually as well as collectively. It is therefore essential that scientific knowledge of people´s cognitive and other limitations is brought to bear on the issue of how to prevent such extreme circumstances to occur.

Arguably, financial markets such as those for stocks and credit overtax actors’ capacity to make rational judgments and decisions. In product markets with full competition, prices represent the true value of the products offered. This does however not hold in stock markets where stock prices, due to excessive trading, are more volatile than they should be if reflecting the true value of the stocks. Psychological explanations include cognitive biases such as overconfidence and overoptimism, risk aversion in the face of sure gains and risk taking and loss aversion in the face of possible losses, and influences of nominal representation (money illusion) of stock prices. If no cognitive biases (strengthened by affective influences) exist or only some actors are susceptible to such biases, individual irrationality in stock markets would be eliminated. This is however not what evidence indicates. Still, in order to understand stock market booms and busts, it is necessary to take into account the tendency among actors to imitate each other. In de-stabilized stock markets, experts are less likely to loose money than lay people who lack skill in constructing stock portfolios that effectively diversify risk.

Credit markets allow people to lend money for investments that will pay off in the future. Yet, under extreme circumstances credit lenders offer loans without appropriately considering the risk borrowers run of not being able to pay back installment rates. Global credit excesses in general, and the current sub-prime mortgage crisis in particular, also show that households often accept risky loans. Furthermore, their preparedness to use credit has been increasing and credit is no longer solely a means of investing in the personal future. An example is that, in the new member states of the European Union, citizens having a desire for a Western living standard are increasingly prepared to use credit.

Credit use is a process consisting of different stages of decision making, starting with purchasing a product for borrowed money and ending with paying back the borrowed money. Decisions to save now in order to buy a desired product in the future, or not to save but to borrow money and save later, are intertemporal choices with consequences at different points in time: The rewards of possessing a commodity immediately or in the future are traded off against the costs of paying back borrowed money by installment rates or paying the price at once in the future.

Purchase decisions involve two interacting choices preceded by information search: Choice of the product and choice of the method of financing. In contrast to search of information about the product, only a small percentage of credit users search extensively for credit information prior to credit take up. The probability of search increases with the borrowed amount, the amount of previously experienced debts, higher income, educational level, and for credit novices. Furthermore, credit users fail to correctly anticipate the decrease in the experienced pleasure from the credit-financed product.

They also experience decreasing pleasure with the acquired product and increasing strains with the continuing payments. In order to deal with this hedonically unsatisfactory state, credit users are tempted to borrow again, and thus possibly slide into problem debt. There is also a reciprocal interaction between the pleasure derived from consumption and the pain associated with paying. As long as a purchased product is not fully paid, pleasure of consumption would be attenuated by painful thoughts about the remaining payments. Therefore, loan payments would become progressively less burdensome if the outstanding debt balance and the associated pain are shrinking more quickly than the benefits of consumption. If payment and consumption are mentally coupled, credit financing would only be accepted for long-lasting goods that slowly depreciate in value, so that the pain of paying is buffered by the benefits derived from the consumption of the product.

In coping with economic hardship caused by financial crises and economic recessions, households use a hierarchy of tactics for adjustment, including buying cheaper, buying less, buying higher quality (more enduring products), and buying fewer (or selling) durables. Since the last implies life-stylechanges it is a last resort even though it would be the most effective way of coping. Younger people are more flexible than older people. Yet, older people, who have experienced economic recessions before, are better able to cope than younger people without such an experience. Pessimistic people and people in lower socioeconomic strata adjust by buying less, whereas optimistic people and people in higher socioeconomic strata continue their consumption and lifestyle by buying higher quality and enjoying more enduring products.

People should be taught budgeting and “mental accounting” techniques to become aware of the possibilities of curtailment by taking account of their spending on a variety of expense categories. The use of credit cards makes mental accounting more difficult and should therefore be discouraged. Implementation of counter-measures is however not easy. There are large differences between people in financial knowledge related to age, gender, level of education, and occupation. Most people furthermore dislike to think about and to compare financial products. Many people even lack the motivation to acquire the knowledge about financial products and procedures needed to function in a complex financial world, where they increasingly become responsible themselves and can rely less on the government for protection and support.

A detrimental consequence of financial crises is the loss of trust in financial institutions. Seven determinants of trust (and regaining trust) in financial institutions are discernible: competence, stability, integrity, benevolence, transparency, value congruence, and reputation. The first four are necessary pre-conditions or “dissatisfiers” that bring trust from negative to neutral. The last three are “satisfiers.” Achieving some or all three would bring trust from neutral to positive.

Some argue that asset bubbles are started by greed fuelled by overconfidence and optimism (as well as low interest rates and inexpensive credit), “madness of crowds” and self-fulfilling prophecies encouraging people to do things they would not do on their own. This results in momentum buying where “real” value becomes irrelevant. It therefore seems fruitless to outlaw mass financial euphoria if it were imbedded in the “human psyche.” One may ask how financial institutions can be changed to become more responsible. An example is the inclusion of long-term environmental, social, and corporate governance considerations within investment processes to achieve both financial and social outcomes. This requires removal or change of conventions that favour remuneration systems based almost entirely on short-term performance. Making required cultural shifts is however no easy matter but because people in any group, including those in financial institutions, are not entirely homogeneous, minorities of open-minded, socially responsible thinkers exist and now perhaps is the time when they are more likely to be listened to.

A policy-relevant insight is that whereas increasing material wealth in already affluent societies has small effects on citizens’ life satisfaction, shrinking material wealth in times of economic crises and recessions may have a more profound effect. In affluent societies preventing shrinking material wealth should therefore have higher priority than increasing material wealth.

Keywords: Psychology; Financial Decision Making; and Financial Crises

82 pages, September 29, 2009

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