Three Big (and Teachable) Obstacles to Sound Money Decision Making

By Barbara Kiviat

October 18, 2016

The rise of behavioral economics has popularized the idea that individuals are beset by a raft of “cognitive biases” when they process information and make decisions. This has broad implications for the way we should approach financial education.

Researchers from the University of Oldenburg in Germany offer a long list of teaching points in the newly released International Handbook of Financial Literacy. Here are three thoughts on how to battle common mistakes from Dirk Loerwald and Arne Stemmann, taken from the chapter “Educational Implications of Biases in Financial Decision Making.”

Overconfidence People often over-estimate their abilities in all sorts of endeavors, from driving a car to making financial decisions. They may also suffer from an illusion of control, thinking they guide events more than they do. One objective of financial education should be teaching the ability to know one’s limits. Case studies of financial failures can be an effective teaching tool. So too may be exercises that reveal an individual’s actual and perceived abilities. Such lessons help make the point that it’s worth assessing how much one actually knows.

Framing Who hasn’t heard that a particular stock is up 20% over the past 30 days and wanted to jump in? The concept of framing describes how people make decisions differently based on how information is presented. With investments, that means learning to seek out data on long-term performance to avoid getting caught up in speculative hype. More generally, people should look for information presented in a variety of ways, or even calculate it on their own. For example, before new regulations mandated that auto dealers translate miles-per-gallon into money spent on gas each year, that calculation was a must-do for any cost-conscious car buyer.

Self-control Wanting to take financial action—say, saving 10% of every paycheck—and actually doing it are two very different things. Economists sometimes refer to present bias, or the tendency to value immediate rewards relative to ones that will come in the future. But even when one values the future, acting in line with those values can be tough. The best tool to give students for dealing with this dynamic may be learning how to find ways to commit to financial action in advance. For example, most banks will happily let customers set up an automatic transfer of money every month from checking to savings.

Zooming out from particular cognitive biases, the bigger lesson is that it’s not enough to simply teach students how to think about money. To have the best shot at making good financial decisions in the real world, they also need to learn how to think about how they think.

Posted in Bank of Dad, Youth on October, 2016