Forschungs- & Entwicklungsinformationsdienst der Gemeinschaft - CORDIS

Final Report Summary - NAIVE DEBT MANAGMENT (Heuristics and Biases in Debt Managment)

Financial decisions such as managing a debt or investment portfolios require complex decision making. These tasks are particularly challenging in times of ongoing economic instability. For instance, faced with debts of various amounts and diverse interest rates, consumers must decide the order in which to settle their debts. Issues of debt management, investments payment priorities and ethicality in the economic world are also crucial to financial institutions such as banks and credit companies. These organizations must understand how their borrowers prioritize their repayments to be able to estimate the probability that their loans will be paid back, and the tradeoff between profits and reliable financial service. This research project identified heuristics and biases that are likely to affect consumers in managing their financial accounts and explored their implications in the financial world and in contexts of personal obligations. Specifically, we examined when consumers’ financial behaviors are aligned with normative strategies and when they lead people to make predictable but irrational decisions.
To explore debt behavior in an experimental setting and compare it to the rational benchmark, in this project we developed a computerized debt management game. In the game, each participant faces multiple debts of varying amounts and annual interest rates. Participants can manage these debts by allocating money from their available cash to the different debts. The game is incentive-compatible and players are required to minimize their amount of total debt by the end of the game. Results from the first stage of the project (Amar, Ariely, Ayal, Cryder & Rick, 2011) supported our behavioral predictions and revealed consistent evidence of debt account aversion (DAA). That is, participants in our two conditions (with or without savings) consistently paid off small debts first to reduce the nominal number of debts, even though the larger debts had higher interest rates (Figure 1 illustrates the amount of these irrational allocations). Ultimately, debt account aversion and other biases such as interest rate neglect and irrational savings of cash led consumers to suboptimal financial decisions. They won the battle (closing small debts), but lost the war against their total debt.
During the entire project we used revised versions of this interactive game as well as different complementary experimental methods to advance our seminal findings in three main directions: (1) identify sources of suboptimal financial behavior (2) expand our understanding of individual differences and the processes underlying these biases, and (3) explore techniques that could be employed to direct consumers toward more optimal and ethical decisions.

In a series of studies on information processing style we addressed Aims 1 and 2, and showed as predicted that DAA tendencies are positively correlated with opposite tendencies for over-diversification in the gain domain, and both are more prevalent (like other biases) among low-rational individuals (Ayal, Hochman & Zakay, 2011; Ayal, Zakay & Hohman, 2012). These results lend weight to our claim that low-rational individuals, who are more sensitive to context cues, are more prone to utilizing irrelevant attributes of the information provided to them (see also Ayal & Beyth Marom, 2014; Ayal & Klar, 2013). This message was elaborated in a recent paper (Ayal, Rusou, Zakay & Hochman, 2015), where we showed that individual differences in information processing style are flexible and can be modified by situational factors. Specifically, Factors that induced an analytical mode of thought improved the quality of financial decisions.

To address Aim 3, we consistently tested different ways to reduce irrational decisions in our experiments, and specifically debt account aversion. For instance, we found that eliminating participants’ ability to completely pay off small debts actually improved their overall financial situation. In addition, a display that highlighted the total amount of interest accumulated helped consumers to focus on repaying high-interest debts (Amar et al., 2011; Ayal et al., 2012; Ayal, Amar & Rusou, in preparation). Although none of these interventions would improve the financial situation of a financially optimal consumer, they both improved the financial situation of naïve participants in our experiments by disrupting their intuitive biases. In the same vein, Ayal et al. (2015) suggested practical directions to help individuals better adjust their processing style to the situation at hand, a technique that may assist people in making optimal financial decision. Ayal and colleagues (Ayal, Gino, Barkan & Ariely, in press; Barkan, Ayal & Ariely, 2015) have also proposed a framework of psychological principles to grasp the ethical conflicts in financial decisions, and encourage adherence to high ethical standards.

Along with its theoretical contributions, this research program has been consistently covered by leading financial newspapers in Israel such as The Marker, Calcalist and Globes and has important practical implications for the public. In particular, the findings from in this project and the identification of the psychological forces that lead to irrational financial decisions can become the building blocks to redirect these forces, and create tools and procedures that can guide people toward more effective and ethical financial decisions.

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