Decoding Decision Making

Whether they stood before the room discussing the influence of credit card minimum payments or hurricanes, all of the speakers at a conference this fall at the Federal Reserve Bank of Cleveland aimed to deepen our collective understanding of how individuals make financial decisions.

One researcher presented his work on how living through natural disasters affects an individual’s aversion to risk.

Another discussed how limiting the return horizon investors can see in mutual fund performance reports affects the risk appetite investors have. (When they can’t see more volatile, monthly returns but are shown the smoother, annual returns, individuals are likelier to invest in riskier assets.)

The Household Economics and Decision Making Conference’s first speaker, Maya Shaton of the University of Chicago Booth School of Business, noted there are “important public policy implications” of her research, which she said shows that the manner in which investment returns are displayed affects how people invest.

Her work “The Display of Information and Household Investment Behavior” examined what happened in Israel when regulatory reform changed the return horizon that certain retirement fund investors could see to 12-month or longer horizons from 1-month horizons.

One result? “We can see that following the regulation, there’s a significant increase of inflow into riskier funds [and] there’s less outflow coming out of those riskier funds,” Shaton said. “This effect is economically significant and also could have an impact on total accumulated wealth at retirement.”

So, she asserted, it’s important to think not just about what information is being disclosed to individuals, but how that information is displayed, as well.

A developing field of research

The papers presented during an academic conference are not final products, and the recommendations made by the discussants may change what the papers find, notes Emre Ergungor, assistant vice president and economist with the Cleveland Fed, who organized the conference with Stefan Nagel of the University of Michigan, Ann Arbor.

That said, the conference’s very existence is evidence of the growing emphasis on research into household decision making.

“We recognize this is important,” Ergungor says of the developing field. “But, we’re not there yet.”

More than one researcher noted at the conference that historically, standard economic models have predicted little role for personal experience in future decision making.

One presenter, Santosh Anagol of the University of Pennsylvania, put it this way: “There’s an empirical challenge in general in trying to understand the relationship between experiences and future behavior.”

However, newer models, including some shared during the Sept. 25 conference, are exploring the implications of personal experience. And this includes Anagol’s work around how investors who won shares of an initial public offering through a randomized lottery in India behaved after they won those shares.

The short, preliminary answer of his work titled “The Effects of Experience on Investor Behavior: Evidence from India’s IPO Lotteries” is this: Those who experienced gains were more likely to apply for future IPOs and increase trading in their portfolios.

Individual choice, regional and national reach

The day’s presentations also highlighted research about how lifetime experiences such as difficult economic times influence individuals. One conclusion its author discussed is that households that have lived through conditions of higher unemployment consume significantly less after controlling for income, employment status, and other characteristics.

Others found and discussed how households that expect inflation to increase were more likely to purchase durable goods.

Lisa Kramer, a discussant who analyzed one presenter’s research, felt the conference as a whole highlighted the role of policy in managing financial outcomes.

“All the papers at the program today show us that individuals’ decisions matter at the economy level,” said Kramer, a professor of finance at the University of Toronto.

“We need people to be willing to take financial risk,” she continued. “We need money not under mattresses; we need investors to help finance business innovation. If they don’t, investors have less money in retirement, and businesses have less of it to use to innovate.”

The examination of how and why people make financial decisions is important because individuals’ decisions are important to the health and vitality of the region in which they live, says Paul Kaboth, vice president and community affairs officer for the Cleveland Fed, which serves Ohio, western Pennsylvania, the northern panhandle of West Virginia, and eastern Kentucky.

“We live in a region that’s called the ‘Rust Belt,’” Kaboth says. “It has a lot of needs. A good portion of our district is Appalachia, which has been poor for more than 60 years. When we have research that shows that they [low- to moderate-income households] are not constantly making poor decisions because of something innate, that there are other factors, it makes it so we can make policy choices to help them make good choices.”

On a national scale, household economics is very relevant to policy issues the Federal Reserve System faces, noted Cleveland Fed president and chief executive officer Loretta J. Mester. She cited how one key to forecasting inflation is inflation expectations, a fact which makes it important to understand how people form their inflation expectations and what anchors those expectations.

“Understanding how people make their decisions is something the Fed needs to know about, if only because consumer spending is two-thirds of our economy,” Mester added.