Bias in financial decision-making

Bias, Banking and Financial Purchases

According to behavioural economists, financial decisions are likely to be subject to decision making bias. Given the nature of modern banking, made increasingly complex following deregulation in the 1980s (Big Bang), and with the subsequent development of new financial products and securitisation, rational decision making was made less likely. This, behavioural economists argue, is because individuals default to System 2 decision making, and use compensating strategies in the face of complexity such as rule of thumb and other heuristic devises. Optimistic framing by the financial institutions prior to the financial crisis may  have created a choice architecture which increasingly diverged from rational decision making.

Taking the sub-prime housing market and related mortgage products as an example, a common rule of thumb which guided decision making  –  ‘invest in property; you can’t go wrong’ – may well have been the defaut position for many buyers. This position is likely to have guided mortgage applicants (especially first-time buyers) in the face of highly complex decisions, as well as enable  them to make quick, often ill-thought through, decisions as properties were ‘flying off the shelf’.

It is unlikely that many of these mortgage applicants read or understood the terms of their contract. It also meant that, in the drive for sales, sellers of mortgages used convenient rule of thumb guidelines to make quick judgements about creditworthiness. Hence, both parties in the increasingly ‘toxic’ sub-prime market made less than rational decisions – clearly it was not in their self-interest, nor those of their families, to take on unrepayable debts. Hence, we can argue that transactions were based on a false reality with little understating of how the market might move in the future.

Unlike tangible goods and face-to-face services, buyers and sellers of financial products must rely much more on heuristics and trust, but when a financial market ‘gathers steam’ the pressure is on to buy (or sell), and the probability of a rational choice declines. The raises the question of regulation and intervention, including behavioural nudging.