Persuasion in Household Finance: New Evidence, New Applications Jonathan Zinman Department of Economics Dartmouth College Federal Reserve Bank of Boston Consumer Protection Week Conference March 29, 2006

Plan for the Talk Two new pieces of evidence showing that persuasion has strong effects on consumer borrowing decisions Practical implications of this type of evidence –Sprinkled with related findings on savings decisions

Study #1: What Psychology Worth? By: Bertrand-Karlan-Mullainathan-Shafir-Zinman Researchers worked with large consumer lender in South Africa to send direct mail: –To former, experienced clients –With randomized interest rates Very expensive (200% APR), short-term (4-month) loans Market looks like a cross between payday loans and old small loan/finance company personal loan market –With randomized presentations of substantively identical offers….

What Drives Consumer Financial Decision-Making? Say you got this letter…. what might drive whether you take a loan or not? –Economics says: price –Psychology says: price and lots of “contextual” factors Mood (emotions) Complexity of decision (so some presentations more effective/salient than others) Firms often refer to this as “value-based” features

So How Test Importance of Psychology in an Economic Decision? 1.Design marketing “features” that are based on “what works” in lab experiments in psychology 2.Lender randomly assigns these marketing features in direct mail 3.Measure impact of marketing on loan demand (takeup decision)

Marketing Features Tested Table size (information overload) Comparison to competitor (gain-loss) Photo (cue) –Race (mis)match –Gender (mis)match Promotional giveaway (“congruence” frame) Suggestions –Priming call –Loan use

Findings: Marketing Treatments Some “worked” (increased takeup), some didn’t When work, marketing effects very large On average, marketing effects very large –Effective marketing increases loan demand as much as a 20-30% drop in the interest rate Effective marketing dulled price sensitivity

Study #2: “Fuzzy Math” Stango & Zinman project studying a particular, prevalent cognitive bias and its impacts on financial decisions & markets Motivation…. do you ever wonder why “monthly payments” marketing is so prevalent?

Marketing Payments, not (loan) prices The more things change the more they stay the same….

The Denver Post March 12, 1980 La Prensa de Minnesota March 31-April 6, 2005.

Our Explanation for this: “Payment/Interest Bias” Give consumers all other loan terms but NOT the interest rate, and they systematically and dramatically UNDERESTIMATE the interest rate associated with a loan (offer)….

Payment-Interest Bias: Facts First documented in 1960s and 1970s –Early finding impetus for Truth-in-Lending But largely ignored by social scientists since early 1980s –So most recent data is 1983 Stango & Zinman first to systematically explore possible impacts of this bias on decision-making, the functioning of financial markets

Payment-Interest Bias: Findings Conditional on a rich set of household characteristics and/or loan characteristics, biased consumers are: –Less likely to comparison shop for loans –More likely to shop on non-price terms –More likely to have financed a recent large purchase –More likely to borrow from nonbank lenders (finance companies, retailers) –More likely to pay higher interest rates when borrowing from nonbank lenders Some evidence that consumers are less price sensitive when borrowing from nonbank lenders –Less likely to have saved in the past year –And they have much less wealth

Related Policy Issues Disclosure “Predatory Lending” Our findings echo stylized facts: –Violations (still) prevalent, and incredibly so in our sample period (Fortney 1986) –Non-bank lenders much more likely to be prosecuted (GAO 2004) –These lenders use marketing techniques that highlight monthly payments and obscure true borrowing costs

Practical Implications What do in light of this type of evidence? 1.Problems with Traditional Approaches: –Education –Information –Prohibition 2.New Approaches

Problems with (Financial) Education “Education” = teaching problem-solving skills Decisions are complex Biases are prevalent, may be deep –Lack of numeracy E.g., payment-interest bias incredibly widespread –Lack of comfort with numbers, finance even among numerate Key decisions are often low-frequency– little opportunity for learning-by-doing, reinforcement –Examples: car purchase (with loan), retirement plan

Problems with Information-Provision “Information” = disclosure, teaching decision heuristics Problems: –“Information overload” –Resistance

Problems with Prohibition The usual economic costs, plus: Underground markets may be even more “high-touch”, able to exploit biases

New Research Suggests and Develops New Approaches 1.Product Presentation 2.Social Marketing 3.Product Development

New Approaches to Product Presentation Not fancy marketing, but…. “Optimizing defaults”: –switching 401k defaults from “don’t participate” to “participate” has huge impacts on savings, even when there is a clear opt-out (Madrian and Shea; Laibson and co-authors) –showing a different example loan maturity has huge effect on maturity chosen (Karlan & Zinman 2005) Concise is nice: beware of information overload –BKMSZ on loans –Iyengar et al on savings Mental accounting and goal-setting (Karlan, Mullainathan, and Zinman ongoing)

New Approaches: Social Marketing Use marketing to spur more deliberate (better?) decisions –What’s good for the (rapacious corporate?) goose is good for the (benevolent?) gander Examples: –Punam Keller on mammograms: appeal to family rather than self –Karlan-Mullainathan-Shafir-Zinman: designing marketing approaches to encourage saving

New Approaches: Product Development Can we stop consumers from borrowing too much? Don’t know yet. But we can help them save more…. Economists have developed 2 successful “commitment savings” products motivated by evidence from psych and econ: –SMART: Thaler and Benartzi (2004) –SEED: Ashraf, Karlan, and Yin (2006)

New Approaches Require Process Innovation Psychologically-driven interventions inherently require continued testing and fine-tuning –Lack of general psych theory –Importance of particular contexts Sophisticated firms (credit card companies, Amazon) have recognized this, built randomized-control evaluation of pricing and marketing strategies into their day-to-day operations Academics are now working in partnership with smaller firms, NGOs, and public agencies to bring these tools to the masses

Closing Thought Evaluate: –is what you (or your grantees) are doing effective? –do a “gold-standard” (randomized-control) evaluation whenever possible –get outside (academic) help Innovate –again, collaborations w/researchers can be productive Disseminate

A Virtuous Cycle Innovate Disseminate Evaluate