Alexandra Fiorillo, VP at ideas42 and a Populist Advisor, discusses the application of behavioral economics to financial services in the first of two interviews with James Militzer of the William Davidson Institute. This post originally appeared on NextBillion.
Here are some undisputed financial truths: It’s good to pay your bills on time and save for a rainy day. It’s bad to live beyond your means and carry too much costly debt.
We all know those things. Yet billions of people, even those with high educations and significant disposable income, struggle with them.
Why is basic finance so hard for so many? And what can be done to get people to make wiser choices? If you’re working to alleviate poverty, cracking that code could reveal a treasure trove of insights that could make your work more effective and improve people’s lives. That’s why we’re excited to have ideas42 as a content partner on NextBillion Financial Innovation.
ideas42 is a non-profit “behavior design lab” – a consulting organization that specializes in behavioral economics, the study of how market decisions are made and the mechanisms that drive people’s choices. Their goal is to use insights from behavioral economics for social good, focusing on problems like consumer finance, energy efficiency, education, the uptake of social programs, economic mobility and health, both within the United States and in developing countries. I spoke with Alexandra Fiorillo, a vice president at ideas42, about how behavioral economics can be used to promote financial inclusion and improve lives at the BoP. In part one of our interview (below), she gives an example-packed overview of the principles of the field. In part two, she describes how behavioral economics can be used to design better financial products and promote healthier decisions.
James Militzer: How does ideas42 apply behavioral economics to financial decision-making?
Alexandra Fiorillo: We try to leverage psychologists’ and economists’ insights about human behavior and how they make decisions. We use these insights to help tweak or redesign existing products or programs so that they better meet the needs of human beings’ actual behaviors, rather than the idealistic vision of what we hope individuals act like. We have done a lot of work in the domestic asset building space as well as innovative financial products in developing countries. We also have developed an innovative approach to financial education for microentrepreneurs that we hope to scale globally.
JM: Can you give an example of how behavioral economics has been applied successfully to promote better financial decisions at the BoP?
AF: There is an example from Malawi that we like to use, related to agriculture finance, that addresses a very specific example of financial need.
If you think about the harvest cycle, farmers get a lot of money right at harvest time when they sell their crops, and then they have to spread that money out over time until the next harvest cycle. And sometimes they spend too much when they’re flush with money, and they run out before the next harvest. This can lead to farmers not investing financial resources in things such as fertilizer that will help increase their crop yields during the next harvest, even when they have stated a preference for using such inputs. To address this self-control challenge, a group of researchers came up with the idea of designing a commitment savings device that lets farmers “protect” their financial resources during times of low financial means, so that when the harvest comes, they’ve already committed themselves. The idea is that the farmers lock up some of their money and can use it at a time of their choosing. In one study, farmers who participated in this savings account had higher crop sales because they bought and used more inputs such as fertilizer.
JM: You’ve written about how more information doesn’t necessarily translate into better decisions. Could you explain that concept, and how it relates to financial services?
AF: There is a well-known study in which researchers tested the sales of two different groups of jams in a supermarket. In one, people were choosing between six different types of jam. In the other, they were choosing from 24 different flavors and brands of jam. Forty percent of shoppers stopped and considered jam when presented with six types and 30 percent of them purchased, as compared to 60 percent of shoppers stopping to look at the 24 types of jams, of which only 3 percent purchased.
The concept of information or choice overload helps us understand that humans sometimes make quicker or more financially sound decisions when presented with limited choices. (Of course it depends on the situation.) So the opportunity to design potential choices that individuals have - whether it’s information, products or other things - is very powerful. And this plays out in financial services. I was the COO of an organization called MicroFinance Transparency that fundamentally believes in empowering consumers by giving them information. But we found very quickly that just providing information to financial consumers does not mean they’re going to turn that into better decision-making. You need to select the key pieces of information that are salient and meaningful for the consumer – the information would really help them become more financially empowered. Then you need to simplify the information and package it in ways that are very actionable and digestible for the consumer.
JM: Talk a bit about heuristics – what are they and how do you use them?
AF: Heuristics are “rules of thumb.” One of our founders is Dr. Antoinette Schoar, a behavioral economist and professor at MIT. She designed and tested a heuristics-based financial education program for entrepreneurs who run businesses at the bottom of the pyramid. Instead of giving them tons of training or information on accounting or financial management, she wondered what would happen if we just taught them a few solid rules of thumb that are based on lots of research about enterprises and how they work. What if we just gave them five general principles that they could apply and use in their business?
The field test had a control group who received no intervention, a rules of thumb/heuristics-based intervention group, and then a group who received more formal, traditional training based on accounting and financial management. The heuristics-based group performed very well on a number of key indicators. We looked at measures of revenues in the business; we looked at how they manage their own business finances; we looked at sustained behavior change over time, where they were actually doing these heuristic-based practices many months out. The results showed that if you present information in ways that are simple and actionable, you tend to see better outcomes.
JM: How can heuristics simplify something as complex as running a business?
AF: A very common tendency among the poor is that if they have an account, at a bank or financial service provider, they tend to have one account that they use for both personal and business purposes. So one of the rules of thumb we are trying to propagate around the world is simple account separation – literally physically separating business finances from personal finances – done either in a financial institution or in your home. And along with business and personal accounts, I would personally like to see us try to get people to add a third component: savings.
Allow me to share an example of how this might play out. In developing countries where there are big open markets, a lot of individuals belong to that market’s cooperative and rent a stall at that market. In some countries, Ecuador for example (where I lived some years ago while working with Banco Solidario), the business operators are given an apron, branded with the name or logo of the cooperative. The apron is meant to be a kind of uniform, but it also has pockets. One innovation that Larry Reed (of Microcredit Summit) shared with me is teaching the entrepreneurs who work in these markets to use two or three of these apron pockets as separate “accounts.” You start in the morning with a certain amount of cash in your “personal” pocket, a certain amount of cash in your “business” pocket, and as you’re transacting throughout the day, you should be doing any business transactions out of that business pocket. If you want to pay yourself a wage - which is another one of our heuristics rules of thumb (“assign yourself a wage for the month”) - you move some money out of your business pocket into your savings or household pocket. This sounds like such a simple tool, but it has a profound impact on financial behaviors for people’s business and household.
Because one of the things we found is that people don’t always know how profitable their businesses are or are not - which is a really important thing to know. Where are you losing money? Where do you need to invest more time or resources? Can you afford to free up your own time or your children’s time by paying a worker? Can you allow your child to go to school, rather than working in the business? There are so many potential long-term implications for the health of the business, but also for the health of the family.