Posted: 6th December 2013
“In theory, there is no difference between theory and practice, in practice there is a great deal of difference.” – Al Rolf, as quoted in “Predictably Irrational” by Dan Ariely
In theory we make important decisions such as those with significant financial implications based on a rational evaluation of the salient facts and then select the option that represents the best outcome. In practice we act very differently, hence the study of behavioural economics i.e. the academic assessment of why we act in the way we do. So why is everyone talking about behavioural economics and what is all the fuss about?
We all make decisions every day; so many that we begin to forget that that we even make some because we become unconsciously competent. Unconscious certainly, but how competent are they really? Think about the number of times you have walked into a supermarket to buy an item only to leave with three because they were on a three for two offer. Or you think have saved money by buying the brand with the 33% extra free only to find out that it is in fact 50% more expensive than your usual brand. Supermarkets get us; they understand us. Think about what that clubcard or nectar card knows about you and your consumer behaviours.
Benefiting the customer
In retail financial services we do not know our customers quite as well as we think or, possibly, should. This is the reason the Financial Conduct Authority’s (FCA) published its first occasional paper on behavioural economics last April. The paper highlights the fact that customers make irrational decisions. Firms know this and some exploit it by using tactics such as pre-ticked boxes for online products or dual pricing for new and existing customers. The presumption is that firms know the existing customers are generally apathetic to change and reading small print.
The FCA is aiming to reverse this tide. Rather than use customer biases exclusively for the benefit of the firm, that knowledge can be implemented to the mutual benefit of the customer and the firm.
Irrational consumer trends are hardly new; we see queues outside Apple stores for new releases that are deliberately understocked. We are more likely to choose a restaurant if it looks busy rather selecting it purely on the quality of its produce and service. It is the same with financial services. We may add the £500 arrangement fee onto the mortgage balance without thinking that this could equate to nearly four or five times as much by the time it is repaid. The same way we may pay £20 per month for the current account ‘plus’ with all those great benefits that seem like good value for services that we never actually use.
Where does it fit in?
The FCA recognises that this is an area of fledgling expertise with potential benefits; though this is not a solution to every problem. Behavioural economics is a logical continuation of Treating Customers Fairly and delivering fair customer outcomes. The FCA wants the regulatory system to use behavioural economics to identify where heuristic biases are responsible for causing potentially detrimental outcomes such as where people are being put off switching products through inertia, inattention or even the simple fear of regret from making a wrong decision.
Harness the power of data
The first step for most firms will be to study the data they already hold, much in the same way that Amazon does. It knows exactly when to email us about a new DVD release or album release. By analysing this data your firm will start to see trends, patterns, common attributes and biases that might lead to unsuitable sales. Once issues are identified, appropriate steps can be taken and the control environment (e.g. sales process, adviser training, financial promotions etc.) can be adjusted in order to mitigate these risks.
It should also be possible to use these findings to inform the product design and oversight cycle by identifying ‘hot attributes’ i.e. factors common to unsuitable sales such as sales process, incentives and distribution channels.
Apply knowledge and science
The next, and potentially less obvious, step is to overlay the results of the data analysis with academic thinking and learning and to engage with customers through surveys, workshops and focus groups to further understand the behaviours that drive their decision making. Harnessed properly this enables firms to identify positive, corrective action and help deliver sustainable, long term mutually beneficial relationships between the firms and their customers.
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