Simple rules can ease complex financial decisions
When it comes to money, straightforward strategies, called heuristics, may be invaluable
In Shakespeare’s Hamlet, Polonius gives his son Laertes some famous advice: “Neither a borrower nor a lender be.” That’s easier said than done. These days, many people, businesses and governments accumulate mountains of debt. Average credit card debt in 2013 reached $15,480 per household in the United States, according to financial website NerdWallet. Overall U.S. national debt is rapidly approaching $18 trillion.
There are ways to borrow and lend money wisely, even if Polonius would disapprove. The trick, according to an upstart group of researchers, is to design simple approaches that work reasonably well, even if imperfectly, in particular financial situations.
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These investigators explore how simple rules of thumb that focus on key pieces of information and ignore all other evidence can improve money management. These strategies are known as heuristics. In a business world where managers are often pressured to throw as much information as possible at a complex decision, such as how to price their products, rules of thumb are viewed as flawed products of lazy thinking.
Yet heuristics can outperform number-crunching exercises in fields such as business, where many interconnected, often unknown factors can trigger unpredictable perils, says economist Shabnam Mousavi of Johns Hopkins Carey Business School in Washington, D.C. Given gigabytes of data, bankers and business managers want to use as much of it as possible to make crucial financial forecasts. Studies suggest, however, that less mental effort produces better judgments than complex calculations do in comparably uncertain situations, including deciding whom to vote for (SN: 7/5/08, p. 22) and how to invest money (SN: 6/4/11, p. 26).
Psychologist Gerd Gigerenzer of the Max Planck Institute for Human Development in Berlin refers to less-is-more decision-making tactics as “fast-and-frugal heuristics.” In choosing between two soaps, for instance, a consumer may simply grab the most recognizable brand. Or, a shopper might use one good reason to make a purchase — say, opting for a lower-priced computer over a more expensive model. If there’s no price difference, the buyer may simply select the better-reviewed model.
Now researchers are focusing heuristic investigations on developing uncomplicated budgeting tools for credit card users, based on the type of user they are. Investigators have also uncovered rules of thumb favored by business managers and have started to develop simpler, more effective regulations to govern how banks loan money.
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“In an uncertain world, heuristics are indispensable tools for making decisions, not second-best solutions,” Mousavi says.
To use credit cards wisely in our pay-as-you-go culture, simple strategies are essential, researchers say.
More than two-thirds of people contacted in a 2009 national survey said they possessed credit cards. About half of them reported sometimes carrying a balance and paying interest on it, according to FINRA, a nonprofit firm that regulates U.S. stock-brokers and firms.
New evidence, in the August Journal of Business Research, describes simple online budgeting strategies tailored to different types of credit card users.
Economist Hersh Shefrin of California’s Santa Clara University and market researcher Christina Nicols, formerly of Ketchum Public Relations in Washington, D.C., used data from 2009 surveys of U.S. credit card holders to identify four ways in which people use credit cards. Shefrin and Nicols then worked with the credit card firm Chase, which funded the project, to design heuristics-based online tools for each type of credit card user, ranging from risky to responsible.
Customers with a “make it easy” outlook are most likely to fall into debt, Shefrin says. These folks express little concern about controlling their finances and usually or always make the minimum payment on their balances. A “make it easy” stance characterized 27 percent of cardholders surveyed nationally.
For them, Shefrin suggests, online systems developed by several credit card firms to monitor monthly expenses make sense. In Chase’s system, customers can also create a plan that charges no interest on everyday expenses in return for making regular payments.
“Control seeking” card holders typically pay the minimum amount but almost half try to limit purchases to emergencies or big-ticket items. They could benefit from the same online options, Shefrin says. “Financially savvy” card holders, who pay most or all of their monthly charges on two or more credit cards, often track monthly expenses on their own. Members of this group — which represented 20 percent of the national sample, as did control seekers — might consider shifting to a single credit card with online monitoring of monthly expenses, Shefrin says.
Online expense monitoring could also help those already paying all monthly charges on a single credit card, he adds. This “confident and in control” group made up 33 percent of the national sample.
A simple heuristic such as reducing spending when monthly expenses exceed a preset limit works well for reducing debt with little effort, Shefrin says. That strategy isn’t foolproof. Some people don’t set their spending limit low enough or lose track of their expenses. But since September 2009, 91 percent of nearly 3 million users of Chase’s online budgeting system have managed to make more than their minimum monthly payments. “Heuristics are imperfect, but it is critical not to let the perfect be the enemy of the good,” Shefrin says.
Many business managers take the good over the perfect when grappling with how best to sell their products, suggest two investigations also published in the August Journal of Business Research.
Big companies often determine prices for what they sell based on calculations that incorporate a product’s relative quality, the number of competing products and many other factors. But successful brand managers often prefer to go simpler, setting prices based on one good hunch: their opinions of their brands’ strength in the marketplace, says Alexander Rusetski, a marketing professor at York University in Toronto.
In an online survey of 116 brand managers at U.S. companies, Rusetski presented hypothetical situations in which volunteers described how their team would determine prices for a new product just after a major competitor had launched a similar product.
Two out of three managers favored setting prices by comparing the strength of their companies’ brands to that of major competitors’ brands. Managers of products with superior market shares, profitability and growth rates — or strong brand strength, as defined by Rusetski — set prices higher than those of competitors. Managers of products with relatively weak brand strength favored lower or equal prices.
Researchers know little about how pricing based on brand strength, which can lead to overcharging for powerful brands, influences overall sales relative to another simple tactic — pricing based purely on a product’s quality.
More is known about the effectiveness of rules of thumb used by businesspeople to identify active customers — those likely to continue buying services from a company. Bankers in Sweden and four nearby countries discern active clients by using principles as simple as “an active customer should have had contact with us during the past year and have at least 20 euros on their account,” economists Andreas Persson of the Hanken School of Economics in Helsinki and Lynette Ryals of Cranfield University in England concluded in a second study. German researchers reported in 2008 that similar rules did surprisingly well at identifying which customers of a clothes retailer, an airline and an online CD seller spent the most on those products over as many as four years.
Bank on it
Even the Bank of England, the central bank of the United Kingdom, is intrigued by heuristics. Working with Gigerenzer and his colleagues, Bank of England economists have conducted simulations based on historical data. Their findings indicate that, when calculating how much money to keep in reserve to cover potential loan defaults, simple measures may be the way to go. Decisions based on the amount of a bank’s capital relative to total loans to households and businesses — known as the leverage ratio — can sometimes do better than calculations that consider many factors, including the rate of asset growth, the amount of retail loans relative to retail deposits and many other variables.
Several simple measures of banks’ financial strength from 2006, including leverage ratios, slightly outperformed complex calculations in predicting which of 116 international banks ended up failing during the global financial crisis in 2007 to 2009, the researchers reported in May in a paper published by the Bank of England. That crisis, partly fueled by bad bank loans justified by complex risk formulas, did much to inspire the bank’s interest in simpler approaches.
The Max Planck-Bank of England team is exploring the extent to which decision trees consisting of a few crucial questions can complement other approaches in detecting financially vulnerable banks, says study coauthor Sujit Kapadia of the Bank of England.
Business heuristics are not without risks; a rule of thumb that works well at first can misfire as circumstances change, cautions economist Colin Camerer of the California Institute of Technology in Pasadena. Asking one’s waiter in a restaurant to recommend a dish may be a simple, effective strategy to enjoy a good meal in Europe, where waiters in some countries get no or minimal tips and can afford to be honest, Camerer says. In the United States, though, waiters get fairly substantial tips based on the cost of the meal and are more likely to push the most expensive entrée when asked.
In a volatile financial world, today’s handy investing heuristic can turn sour overnight, Camerer predicts. With so much financial data now available at a keystroke, it can be dangerous to ignore too much information, he says.
Follow your instincts
Still, astute investors apparently exploit an emotional heuristic in which a sense of impending danger motivates them to sell stocks headed for a tumble in value, Camerer and his colleagues reported July 22 in the Proceedings of the National Academy of Sciences.
Over 50 rounds of a lab game, 320 volunteers in groups of 11 to 23 could buy or sell one share of a stock that randomly paid a modest or large dividend after each round. Or, players could buy nothing and earn a small interest rate on their stash of experimental money.
In 12 of 16 games, the average price volunteers were willing to pay for a share of stock rose sharply before plunging by at least 50 percent.
Those who made the most money sold their stock near its peak value, several rounds before declining demand for the stock among players caused its value to plummet. Brain scans obtained from 44 volunteers during the games showed enhanced activity in an area called the insula among high earners shortly before dumping their stocks. Insula activity rises during physical and emotional discomfort.
“A biological early-warning system for danger that includes the insula probably evolved to be overly panicky,” Camerer suggests. Those who heed internal early warnings about stock prices or anything else react to lots of false alarms, which is inconvenient in the short run but ensures that actual threats won’t be missed in the long run, he suspects.
That hair-trigger tendency suggests a rule of thumb fit for Polonius: “Better safe than sorry.”
This article was published in the September 20, 2014, Science News with the headline, “Less is More.”