Emma Wall: Hello and welcome to Morningstar. I'm Emma Wall and I'm joined today by Dr. Sarah Newcomb, Behavioral Economist for Morningstar.
Hi, Sarah.
Dr. Sarah Newcomb: Hi.
Wall: So, what exactly is behavioral science and how does it impact investment decisions?
Newcomb: Well, behavioral science we don't have a very clear definition of. I think it's loosely the way that psychology impacts our financial decision making. But in practice, it's been a lot more specifically directed at some of the known biases that we've able to define and measure, things like loss aversion, confirmation bias, the way that default options or removing choice or limiting choice can help people to make the decisions that they want to make.
And overcome the fact that we're so short-term focused or rather we want to prepare for the long-term but we overestimate the immediate – or overemphasize the immediate rather than the long-term pay-offs.
Wall: One of the things I thought was really interesting that you said just now at the Morningstar conference in Europe. Obviously, you were speaking to a roomful of professionals, but it's the fact that 90% of people are financially illiterate and that's not saying that they are stupid; these are highly-intelligent people, but people who do not spend their all day everyday dealing with finances do not have the same understanding of the market. It sounds simple, but I think it's an assumption that a lot of people don't make.
Newcomb: Well, I think the depth of what financial illiteracy means is something that people don't understand. So, when we are talking about the big five financial literacy questions, one that comes to the top of my head is if you had $100 invested at 2% per year, after five years would you have more than $102, less than $102?
I mean, if you know even simple investment, you're going to have $110. You compound interest. And this is a very simple question; most people get it wrong. So, we are talking about a level of financial illiteracy where people are avoiding even thinking. It's not that they can't do the math. It's that they don't even approach it. They don't even let themselves think about it.
Wall: And this is very pertinent at the moment because the U.K. pension system, I think, both takes advantage of behavioral science in a good way and also in a bad way. So, we've recently had some reforms in the U.K. From last April individuals who are at retirement can get hands on their pension cash. This is totally new. Before you had to buy an annuity, now you can have all that pot for yourself to play with.
And in the accumulation stage, while you are working, contributing to your pension, most people are in the default scheme. I think 99% of people are in a default scheme and they have absolutely no choice and they are happy, going along with their pension pot accumulating never having to think about it. And that inertia, that behavioral science it works in their favor. But then at 55, they could have access to their cash, and they are suddenly given all this choice.
And a lot of the feedback that we've had, both at Morningstar and indeed, the industry has had, is people have decided to even with tax implications take all of their money for cash because it's an asset they understand, the rest is just too complicated. I mean, what would you say to that conundrum? How can we apply behavioral science to that?
Newcomb: I think there are a lot of things going on there. First of all, default schemes do boost enrollment and that is great, especially with people who are financially at risk. At the same time, being automatically enrolled doesn't mean that you are contributing enough. So, for example, in the U.S. a lot of times people are automatically enrolled at 2% which is woefully inadequate.
So, people can be automatically enrolled and think that they are fine because if they don't go the next step of learning about money then they think that they are being taken care of by this government that has enrolled them and then this nest egg, they have never seen that much money before.
And they don't know the potential income stream from that nest egg. They only see that as income. So, I think what we need to do combine nudge psychology and nudge tactics with very simple financial education.
So, there is even a controversy in the academic community around whether we should nudge or teach. I think that there is an argument to do both where in some cases when it's really hard to get people involved at all that initial nudge of an automatic enrollment maybe a great first step, but that's not the solution. You need to still then teach people once they have this asset how do they manage it, and we need to be careful in the way that we communicate about that too, because again this is a foreign language.
So, some of the most promising work in financial education talks about rules of thumb; the simpler, the better. So, especially with people of low financial knowledge, and that is most people, then a simple rule of thumb rather than a whole complex idea goes a lot further because you can remember it; you can bring it into many different circumstances and you remember that rule of thumb.
So, if that rule of thumb is, don't spend on your principal, only spend the interest. That's a very simple rule of thumb. That's a great target, great target. I mean, that may not be realistic for a lot of people, but it's a simple rule of thumb that's easy to understand and easy to act on if you have an asset.
Wall: Dr. Sarah, thank you very much.
Newcomb: Thank you.
Wall: This is Emma Wall for Morningstar. Thank you for watching.
