Money Minded


How emotions, thoughts and biases drive financial decisions—and what community bankers can do about it

By Kelly Pike

Money is built on belief. We believe in the value of the U.S. dollar even though it’s not backed by gold, silver or any other tangible commodity. We believe in the value of a share of Apple or a bitcoin and the markets that tell us what they are worth. But more than that we believe in money itself—and its power.

Yet its sway over us depends on our beliefs. There are spendthrifts and hoarders and misers. There are people who make money part of their core identity, measuring self-worth by net worth. Others give their money away. Some use it to control others, while other people feel controlled by money.

But where do these ideas come from, and how do they drive our financial decisions? These are questions psychologists, economists and those in the burgeoning fields of behavioral economics and neuroeconomics seek to answer, and those answers have valuable insights for community banks.

Origins of belief
Ideas about money are shaped during childhood. Children observe and absorb the way family finances are handled and then often repeat or rebel against those patterns. The child of frugal parents may grow up to mimic their parents’ careful spending or might flout it, spending prolifically to make up for all the things they wanted but never got. In fact, those who grow up poor often feel less in control and are more prone to impulsive decision-making, according to a study in the Journal of Personality and Social Psychology.

Sometimes it’s more a case of nature than nurture. The famous “marshmallow experiment” conducted in the 1960s by Stanford psychologist Walter Mischel gave children two choices: Eat one marshmallow now, or wait 15 minutes and get two marshmallows. Most children couldn’t wait the full 15 minutes, but children with the self-restraint to wait grew up to have higher measures of conventional success.

Similarly, a study by Hal Hershfield, assistant professor of marketing at UCLA, found that people who can more vividly imagine enjoying future goals like a new car or house are better at saving. Conversely, compulsive spenders are more likely to have lower self-esteem, other studies have found.

Rational or irrational?
Economists used to assume that people were both very rational and very self-interested when making financial decisions, yet common real-life behavior such as charitable giving or failing to save for the future contradicts this idea.

Behavioral economics emerged to better understand financial decision-making by applying psychological principles of human behavior to economics. One of the field’s pioneers is Daniel Kahneman, a Princeton University psychology professor who won the Nobel Prize in economics in 2002 for his research with Amos Tversky. They discovered that people don’t conduct detailed analyses to make most financial decisions. Instead they rely on heuristics, or mental rules of thumb, to quickly reach a conclusion.

People who can more vividly imagine enjoying future goals like a new car or house are better at saving. Conversely, compulsive spenders are more likely to have lower self-esteem.
—Hal Hershfield,
marketing professor

Heuristics help people make fast but often flawed decisions due to logical shortcomings known as cognitive biases. These biases include the following:

  • Availability bias. People rely on specific examples when evaluating the likelihood that an event will occur. For instance, during the stock market downturn, many investors overreacted to bad news and withdrew money from the market because they could easily envision losing money but couldn’t imagine future gains.
  • Representativeness bias. People tend to see patterns in random data and often rely on stereotypes. For example, the actions of Wall Street banks can erode trust in community banks too if people see a pattern or stereotype that all bankers are greedy.
  • Anchoring. Once you introduce a number or price to an individual, he becomes anchored to that price and will adjust upward or downward from that point—and not stray too far from it.

Other common biases include optimism bias (or overconfidence in one’s abilities); endowment or ownership bias (thinking something, such as a house, is worth more because you own it); loss aversion (feeling the pain of loss more than the happiness of gain); status quo bias (preferring to keep things as they are); and mental accounting (assigning different values to different piles of money—for instance, playing with “house money” when gambling).

These biases have a lot of power because of how the brain works, as Richard Thaler, a University of Chicago professor of behavioral science and economics, points out in his New York Times best-selling book Nudge: Improving Decisions About Health, Wealth, and Happiness.

The human brain has two systems of thinking: automatic and reflective. The automatic system originates in the oldest part of the brain and relies on instinct. It’s fast and unconscious and can process many things at once. The reflective system resides in the more advanced frontal cortex and is responsible for slow, deliberate thought. When faced with financial decisions, people often rely on the automatic system, which is fueled by heuristics. (Interestingly, a 2011 brain-imaging study of the now-middle-aged original marshmallow experiment participants found hose with more self-restraint had more activity in the prefrontal cortex.)

In his book, Thaler argues that financial institutions and other entities are “choice architects” because the way they design options inherently influences the choices people make. For instance, when companies make saving in a 401(k) the default option for new employees, retirement plan participation increases dramatically.


Overcoming bias
First, researchers must figure out why people make the decisions they make.

“Some of it is not being informed enough, but some of it is very emotional,” says Antoinette Schoar, a professor of entrepreneurial finance at the MIT Sloan School of Management. “Even when people understand a concept, they might still struggle with things like control issues.”

For instance, some lower-income households bounce checks, incur late fees or are short on funds not because their budget is too tight, but because they are disorganized. In an experiment Schoar conducted with ideas42, a nonprofit she helped found to apply behavioral economics insights to real-world problems, researchers worked with a community savings bank to offer financial health checks to struggling households. Half got in-depth financial counseling. They also were given the option to sign up for automatic payments for essential needs such as housing and minimum credit card payments.

Those who agreed to automated payments had fewer fees for bounced checks one year later. Yet many didn’t benefit from this financial optimization because they didn’t want to give up control of their accounts.

“People think this control is somehow useful,” says Schoar, “but when you have behavioral biases and you’re not paying attention, control is useless because you’re not using it for anything good.”

“Banks have to be very careful with giving incentives. An incentive still works, but it’s a very fine balance to walk.”
—Stephan Meier,
associate professor of economics

“People think this control is somehow useful,” says Schoar, “but when you have behavioral biases and you’re not paying attention, control is useless because you’re not using it for anything good.”

Rather than take control, some people just shut down when faced with financial problems and crises. Nowhere was this more obvious than during the Great Recession when many homeowners were underwater and behind on their mortgages.

Working with Fannie Mae and 10 large mortgage lenders, Schoar randomly sent one of two messages to homeowners behind on their mortgage payments: one message that was pleasant and stressed that the lender wanted to help the borrower stay in her home, and one more typical letter that dryly laid out all the options, including the possibility that the home would be foreclosed on in 60 days.

Those who had been in distress 90 or more days—many of whom had been hiding from lender phone calls and messages—only responded to the soft message. Meanwhile, those who were 30 days late responded only to the hard message.

“Even when people understand a concept, they might still struggle with things like control issues.”
—Antoinette Schoar,
entrepreneurial finance professor

“When people are truly overwhelmed or stressed—both emotionally and cognitively—if you target them with what looks like a very dry and threatening message because it lays down negative consequences, people totally shut down and go into avoidance mode,” Schoar finds.

Fighting heuristics with heuristics
Financial education has been a key tool for community banks hoping to help customers make better decisions, but sometimes the best way to fight bad heuristics is by replacing them with good ones. Studies have shown discouraging results for financial education’s power to change behavior, says Schoar, but researchers have seen improvement when customers are given new rules of thumb to help make decisions.

“When we teach very detailed, complex financial tools [to small business owners] they say these are very interesting and they are glad to know them, but half a year later they aren’t applying them because there’s too much work in day-to-day life,” Schoar says.

Instead, Schoar has found success in giving small-business owners heuristic tools to address common problems, such as mixing personal and business finances or not knowing which areas of the business are most profitable.

“We give them some physical tricks for how to separate their business from their household, and it makes a big difference,” she says. It’s not as effective as a full analysis, but it can get business owners 80 percent of the way there.

Yet banks must be careful when trying to shape behavior, especially when using incentives. Stephan Meier, an associate professor of economics at Columbia University and former senior economist at the Federal Reserve Bank of Boston’s Center for Behavioral Economics and Decision-Making, warns that social or psychological beliefs often interfere with the reception of incentives.

In one of Meier’s studies, a financial institution sent homeowners a legitimate offer to refinance that would enable them to save hundreds of dollars a month. Logically, homeowners should have jumped at the deal, but just half of consumers did because they didn’t trust that a bank would send such a good offer without a catch. In fact, when the bank sweetened the deal with a gift card for those who refinanced, even fewer people accepted the offer because they were suspicious.

“Banks have to be very careful with giving incentives,” Meier says, noting community banks have an advantage because they are more likely to be trusted. “An incentive still works, but it’s a very fine balance to walk.”

When it comes to boosting savings, incentives need to be structured to help customers reach goals—not increase motivation, which is already high, he says. In a study of female microentrepreneurs in Chile, Meier found that when women set a goal and checked in with a peer group once a week, their rate of savings grew 350 percent and balances doubled. He found similar results when participants had the accountability of a “savings buddy” who was updated with their weekly progress.

Increasing interest rates on savings accounts had no effect.

Part of the problem with saving is that people are “present biased.” They think it will be easier to save tomorrow or next week. In fact, people with greater present bias are typically more impatient, have higher credit card balances and lower credit scores. That makes the ability to steer people around destructive heuristics all the more valuable. Thaler calls it “libertarian paternalism”—influencing choices so that people make smarter decisions but making it easy for them to opt out if they don’t want to participate. It’s an opportunity for community banks, Meier says.

Almost three-quarters of Americans report they feel stressed about money at least part of the time, and nearly one-quarter say they experienced extreme stress over the past month.
—American Psychological Association, 2015

“I, personally, would be willing to pay the same, if not more, for a half-size of the gigantic muffins here in the U.S.,” says the Swiss economist. “If you’re rational, you’ll cut it in half and throw it away, sell it or donate it, but I don’t. I buy a gigantic muffin and eat it and regret it. I’m willing to pay for help if someone will help me make a better decision.

“If financial institutions could figure that out and find the half-sized muffin of financial services, it could be a win-win.”

But for that to happen, community bankers will have to think more about the psychology of money—and the behavioral and emotional issues that influence financial decisions.

Money Anxiety

It’s no secret that money is a source of stress and worry, but stress and worry also impact how people behave with money.

That’s the finding of Dan Geller, author of Money Anxiety and a behavioral economist at San Francisco-based Analyticom, which helps banks make forecasting and pricing decisions. Building on Richard Thaler’s research into analytical and instinctive decision-making, Geller’s research shows that when money anxiety increases, people default to making instinctive financial decisions.

“The way we are designed, the ultimate goal is survival,” he says. “When we are faced with anything to do with uncertainty, then we use our reptilian, or instinctive, brain to make a fast decision. It’s the same part of the brain that told our ancestors to run when they faced a tiger in the woods.”

In the case of a deteriorating economy and rising unemployment, like during the Great Recession, people instinctively hoard resources—increasing savings and cutting spending.

They don’t stash the cash just anywhere. At times of high money anxiety, people tend to put those funds in liquid accounts like checking, savings and money market accounts even though they get a better return in long-term CDs, despite early withdrawal penalties, he says. That’s because the analytical work of assessing options is too overwhelming when customers are thinking instinctively.

The lesson for community bankers is twofold, Geller says. First, banks should prepare for an influx of cash into liquid accounts instead of long-term accounts during the next recessionary cycle.

Second, banks can benefit from integrating behavioral economics into decision-making, including deposit pricing. At a time of thin margins, banks can incorporate behavioral factors, such as the consumer confidence measures in the University of Michigan’s Consumer Sentiment Index, as mediating factors or variables to increase the precision and efficiency of pricing.

“Right now banks are very mathematically oriented,” Geller says, encouraging banks to embrace psychology the way the field of economics has. “Behind those numbers, there are people.”

Setting Limits

It’s psychologically more painful to part with cash than pay with a credit card, making it relatively easy to rack up debt by buying with a card. But what if credit cards came with tools to help consumers set limits?

That’s a question posed by Dan Ariely, Alfred P. Sloan professor of behavioral economics at MIT, in his New York Times bestselling book Predictably Irrational: The Hidden Forces That Shape Our Decisions. In it he proposes a “self-control credit card” that would let people set limits for spending in different categories, stores and time frames.

For instance, cardholders could set a grocery or entertainment budget. They’d also set a penalty if they went over the limit—like having the card rejected, making an automatic charitable donation or having an email alert sent to a spouse or friend.

Ariely says he met with a large bank about the idea and never heard back. Now he has started Common Cents Lab as part of his Center for Advanced Hindsight to partner with banks, credit unions, FinTech companies and others “to test behavior-based interventions aimed at increasing the financial well-being for low- to moderate-income Americans,” including the unbanked. For instance, it’s working with one credit union “to increase rainy day saving by leveraging mental accounting and saliency.”

Learn more about the behavior research at the website,

Kelly Pike is a writer in Virginia.