Even though economics is a social science, traditional economics has historically ignored the human element. Rather than accounting for the complex human variables, economists historically assumed that people always behave rationally and make the best financial choice.
But cost is just one factor in the decision-making equation. Depending on your stress level, family needs, or your time available, you may be willing to pay more, even when you can’t afford it. Additionally, there’s a myriad of psychological reasons that we make purchases. Spending can be emotional, providing a treat for a positive achievement or consolation for a negative one.
Much of the modern banking industry was built on the idea that people optimize their spending and respond positively to incentives. But over the last 15 years, behavioral economics has offered a different opinion. Behavioral economics evaluates the intricacies of human actions and the choice behind how people spend their money. It points out that people do not always act in their best interest and explores the theories that explain why.
In fact, Adam Smith, the father of modern economics, originally placed a huge focus on the human element. He wrote about loss aversion and overconfidence in financial decision making in the late 18th century. Unfortunately, much of Smith’s awareness of the human variable fell out of fashion before economists formalized our current banking system.
Regardless of whether economists are paying attention to human behavior, advertisers are. For the last two centuries, companies have capitalized on the insecurities and social pressures that impact one’s ability to make an objective financial decision. And such marketing has, in the words of Maciej Kraus, “used behavioral science to make you purchase products you don’t really want, in quantities you absolutely do not need, with the money you probably don’t have to impress people you don’t really like.”
As financial institutions, there’s some catching up to do. PFMs are commonplace and customers' expectations of personalization are on the rise. Additionally, behavioral economics can help banks build consumer trust. According to a recent EY survey, respondents ranked a bank's ability to help them meet their financial goals as a key factor in building trust. In fact, both MX and Plaid identified that financial institutions have a ways to go to support the financial health of their customers. A 2021 MX survey identified that banks and credit unions “don’t really help” and 4% said “they make things worse.”
A variety of banks are pushing automated saving features within their digital accounts. Some are even designed to mysteriously identify money that will not be needed and can safely be moved to savings. And while building savings is always a worthwhile goal and a step toward financial wellness, a one size fits all approach doesn’t always work.
Do you have the full picture regarding your customers' financial circumstances? Is their primary savings account currently situated in a neobank with a higher interest rate? Do they need to be contributing more to an employer sponsored retirement plan? Would they be better off paying down a credit card balance than adding to their savings?
Understanding that loss aversion – that people are hardwired to feel more pain over loss than incentives – could inform your app design. Pointing out that a user will pay an extra $3,500 in interest over the life of the loan if they only pay the principal may motivate an increased monthly payment.
But it’s not enough to point out that paying more will save their future self money. The power of compounding interest is well documented, but many who live paycheck to paycheck don’t feel they have sufficient flexibility to add more to savings. A banking experience that focuses on financial health will also help them avoid fees and save money.
Over the next few months, FinGoal will explore key lessons from behavioral economics. If you’re designing or improving your digital banking experience these will be factors you’ll want to incorporate.
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