Financial Decision Making and Present Bias

Topic and Objectives

Present biased preferences induce time-inconsistent behavior in intertemporal decision problems and are one of the cornerstones of behavioral economics (DellaVigna, 2009). One of the most important domains of intertemporal decision making is choosing the structure and financing of consumption patterns, including whether, how, and how much to save and invest money. From a theoretical perspective, individuals with present biased preferences should behave systematically different in these areas than individuals with “standard” intertemporal preferences that feature exponential discounting. This raises the question about the prevalence and severity of time-inconsistent behavior in this area: Are present-biased preferences a determinant of suboptimal financial decision making? Can we use methods from experimental economics to identify individuals particularly prone to making financial mistakes? If so, can we use these measures to customize individual programs aiming at improving the financial decision making of households and thus improve their cost-efficiency as well as effectiveness?

In this project, we want to shed light on the prevalence of present-biased behavior in real-world financial decisions. By collaborating with a FinTech startup based in Berlin, we can access detailed financial account data from approximately 10,000 clients. Using this transaction-level bank account data, we elicit whether people show signs of present bias. The crucial characteristic of this data set is that it is transaction based, allowing for explicit identification of those individuals whose consumption, financing, and savings behavior can be classified as present biased.

Key Findings

• We show that the excessive use of bank account overdrafts is linked to time inconsistency.
• By contrast, there is no correlation between a survey-based measure of financial literacy and overdraft usage.

Policy Implications

• Our results indicate that consumer education and information may not suffice to overcome mistakes in households' financial decision making.
• The distinction between information/education-based (financial literacy) and preference-based (time inconsistency) explanations for poor financial decision making appears crucial. Depending on the relative strength of these mechanisms the associated policy response might differ widely: While preference-based explanations rather point to policies providing commitment devices as a promising approach, information-based explanations call for educational and regulatory responses. In this sense, our results point to the former rather than the latter.