Paul Cohen

We’re awful at personal finance.

 

It’s not because we’re dumb — it’s just that personal finance is a minefield of cognitive biases.

 

Consider almost any cognitive bias: procrastination, planning fallacy, confirmation bias, affective forecasting errors, endowment effects, sunk costs, or hyperbolic discounting. Each of these biases leads to poor decisions that impede our financial goals.

 

Despite the proliferation of cognitive biases in such an important domain, most personal finance apps don’t even attempt to help us make better decisions. Today’s utilitarian banking tools merely replicate first-order IVR-style transactions of the 1970s (e.g., view account balance, transfer money, pay a bill). 

 

A next generation personal finance app — let’s call it a Behaviorally Intelligent Advisor (BIA) — could leverage insights from behavioral science to nudge us to make decisions that serve our goals. To this end, I’ve sketched some early thinking on how one might design a BIA with behavioral science in mind.

 

 

1) Reframe Transactions (and Kill the Ledger)

Unless you have cash flow concerns, the time-based ledger is generally an irrelevant lens on personal finance. A BIA should automatically lump and split transactions to help us think about our money in ways that maximize hedonic value. Prospect theory and mental accounting, which I wrote about in a previous article, inform how a BIA might display financial transactions:

 

• Separate gains. We can maximize the hedonic impact of gains by spreading them across separate temporal instances. For example, receiving two bundles of $1,000 is better than one bundle of $2,000.
• Combine losses. A BIA should minimize the pain of losses by aggregating expenses into a single episode. For example, we’d rather pay $10 in bank fees all at once than pay $1 in bank fees ten separate times.
• Combine small losses with large gains. The interaction of loss aversion (i.e., losses loom larger than gains) with diminishing sensitivity for gains (i.e., $10 is significantly better than $5, but $105 isn’t that much better than $100) suggests that we can maximize hedonic utility by combining smaller losses with larger gains. For example, a BIA might automatically lump your paycheck income of $2,250 and transit expenses of -$100 into a single episode of $2,150. While the resulting income of $2,150 is slightly worse than $2,250, you avoid the pain of an independent -$100 transit expense loss episode. In a similar vein, a BIA might amortize costs over the span of consumption to maximize hedonic value. For example, depending on the flow of income and expenses, it might make sense to represent a mortgage payment as a series of small daily payments instead of a monthly lump sum. This reorganization might minimize the perception of losses, especially if the small mortgage payments are netted against a larger daily gain (i.e., a paycheck similarly amortized over the pay period).
• Separate small gains from large losses. The value function for gains is concave and steepest near the origin, so a BIA could maximize hedonic value by segregating small gains from large losses. Consider the intuition: if you win $150 at a casino, you don’t want to mentally integrate that win with your $5,000 credit card debt. We feel better about a small gain of $150 and a seemingly unrelated loss of -$5,000 from a different mental account than a single integrated loss of -$4,850. A BIA could integrate and split transactions to maximize the emotional perception of our finances.

 

 

2) Set and Frame Goals

 

Labeling our money allows us to control how we allocate our resources, which is particularly important to achieve our goals. Many of us have set of goals (e.g., take a vacation in late September, buy a new refrigerator, and save for a deposit on a car in 6-9 months), but our savings accounts merely represent broad pools of money (e.g., $12,521 in savings) that are untethered to those goals.

 

A BIA should help us create goal-based, partitioned financial accounts that reflect important goals. For example, you might have several goal-oriented pools of money, such as a vacation savings fund (e.g., goal to save $5,000 by September 15th), a refrigerator savings fund (e.g., goal to save $1,000 by end of year), and a new car fund (e.g., goal to save $4,000 by February 1st of next year). You might also want an emergency savings fund and a “fun money” fund. The BIA should solicit your goals and help you decide what you need.

 

Several behavioral tactics might enhance a goal-based account architecture:

 

• Goal acceleration. We exert more effort as we approach goal completion (i.e., the goal gradient effect). Creating an illusion of progress can spur us to achieve our goals more quickly. You’ve likely seen the instantiation of this effect with loyalty cards. Instead of giving patrons a 10-hole punch loyalty card, many restaurants offer a 12-hole punch card initialized with two punches. When we start with two punches toward our 12-hole goal, we return to the restaurant more frequently than we do with the 10-hole punch loyalty card. Instead of framing a financial target based on existing progress (e.g., a goal of saving $4,000 for vacation because you’ve already saved $1,000), a BIA might pre-initialize certain goals with existing funds to create the perception that you’ve already made progress (e.g., you’re already $1,000 into your $5,000 vacation goal).
• Goal chunking. In a similar vein, a BIA could compute the plausibility of achieving each goal given historical financial patterns and intelligently chunk goals into smaller and more achievable subgoals. For example, a BIA might break a $2,500 savings goal into segments of $750, $1,250, and $500. This tactic yields a second benefit: non-linearity likely yields more engagement than the traditional linear (i.e., boring) savings behavior.
• Goal salience. Increasing the identifiability or salience of goals can help fight procrastination. For example, seeing a photo of your daughter will likely encourage you to allocate more savings for her college tuition.
• Social pressure. Many people respond to social cues, and a BIA could leverage the multitude of social motivational mechanisms to encourage goal-directed behavior. Competitions among family, friends, or other small social group may encourage progress. A BIA might also leverage social norms to enhance motivation. For example, if a BIA conveyed that 82% of people in your income range have an emergency fund of at least $5,000, you might be more likely to adopt and make progress toward that objective.
• Consistency. We generally prefer to act consistently with our prior behavior. A BIA might surface our previous actions to nudge us toward normatively desirable behavior (e.g., “Last year you allocated 75% of your tax refund to your retirement plan. Would you like to do that again?”).

 

 

3) Enable Better Decision Making

 

It often takes hundreds of individual decisions to make progress against a meaty financial goal. A BIA should systematically counteract the cognitive biases that would otherwise lead us astray. Behavioral science offers a broad toolkit that a BIA could use to improve decision making:

 

• Precommitment. Since income is typically cyclical, a BIA might analyze progress toward each goal and ask us to precommit to a specific allocation for our next paycheck (e.g., “You’re slightly behind your retirement goal. Do you want to allocate $500 from your next paycheck to your retirement account?”).
• Active choice. In addition to nudging us toward action, prompting active tradeoffs can also mitigate reactance by reminding us of our own autonomy. For example, instead of asking whether you want to allocate $500 into a retirement fund, a BIA might suggest two options: a) allocate $500 into a retirement fund, or b) $400 into a retirement fund and $100 into a “rainy day” fund. This encourages you to make a decision by presenting you with multiple options, and also reminds you that you are in control.
• Concreteness. A BIA should help us understand the concrete tradeoffs of each option, especially among options defined by factors that are difficult to compute, such as compounding interest. A BIA could leverage multiple techniques, such as concreteness and loss aversion (e.g., “I see that you don’t want to make any payments on your credit card this month. If you pay your credit card in full next month, you will pay an extra $40 in interest. If you keep delaying your credit card payments for another year, you will pay an extra $500 in interest.”). Likewise, a BIA could point out that a $500 deposit into a retirement account today could grow to $2,000-$3,000 in 25 years. A BIA might also help counteract the overoptimism bias by accurately representing progress against goals in concrete terms. For example, a BIA might compute a retirement readiness age equivalent (e.g., your target retirement age is 55, but given your finances, your “real” retirement age is 62).
• Smart defaults. A BIA should employ a default configuration that reflects normative financial preferences, such as automatically paying off high interest accounts before allocating income to savings.
• Strategic anchoring. A BIA could use certain behavioral biases, such as anchoring, to counteract others, such as procrastination. For example, a BIA might ask you “How much do you want to save for retirement?” before prompting you to decide how much of your paycheck you want to allocate to that goal.
• Prepayment. Decoupling the pleasure of consumption from the pain of paying increases the hedonic value of experiences. As a result, when we pay up front, we can control consumption and enjoy our experiences more. For example, a BIA could help you budget and prepay (ideally months in advance) for the helicopter ride you’ve been dreaming of so that you’re not thinking about costs while you’re enjoying the experience.
• Cooling off periods. Unexpected income, such as a large bonus, can erode self-control and cause risk-seeking behavior (i.e., the house money effect). A BIA could help us avoid impulsive behavior by instituting cooling off periods that limit use of unexpected funds for a fixed period of time.

 

Thoughtfully crafting a BIA in the personal finance arena is challenging for a variety of reasons, including regulation that may make it difficult to implement some of these concepts. Nevertheless, it’s a useful thought exercise that may spark additional thinking on how we can help consumers make better choices in an important domain.