Consumer Decision-Making in Retail Investment Services: A Behavioural Economics Perspective Executive Summary

November 2010 Overall co-ordination Decision Technology Ltd Academic Participants Nick Chater Professor of Behavioural Science, Warwick Business School and cofounder, Decision Technology Steffen Huck Professor of Economics and Head of Department, University College London Roman Inderst Professor of Finance and Economics, Johann Wolfgang Goethe Universitt Frankfurt

Commercial Participants
Online Interactive Research Ltd

Consumer Decision-Making in Retail Investment Services: A Behavioural Economics Perspective

EXECUTIVE SUMMARY 1 1. Introduction

The EU Consumer Policy Strategy 2007-2013 underlines the importance of empowering consumers, as a key driver of innovation, competition and productivity. However, there is evidence that consumers often fail to make optimal choices and not only because of asymmetric information. Even well-informed and numerate consumers may exhibit systematic departures from welfare-maximising behaviour. This evidence reflects one of the main tenets of Behavioural Economics (BE): the homo economicus of classical economic theory is an over-simplified description of human behaviour. Consumers are not always selfish, rational and independent agents but instead they exhibit a strong interdependency and limited or "bounded" rationality.

2.

According to the fourth Consumer Markets Scoreboard, retail financial services are one of the sectors characterised by substantial market malfunctioning.1 In particular, the 2010 Scoreboard shows that the market for investments, pensions and securities ranks worst out of fifty consumer markets for overall market performance; worst for ease of comparing products and services sold by different suppliers; worst in trust that suppliers will respect consumer protection rules; fourth worst in experiencing problems; and worst for overall satisfaction. The financial environment has evolved so much that consumers are often ill-prepared to make sound decisions about increasingly complex retail financial products. The inability to benefit fully from this market is in part due to limited financial literacy or asymmetric information, but it may also be directly related to instincts driving consumers towards choices which are inconsistent with their longterm preferences. Recent evidence shows that consumers often have limited time to fully understand complex retail financial products. "Herding" instincts and over-reliance on experts' advice may also limit rational reflection.

3.

The purpose of this project was to study the decision-making processes of consumers in the market for Retail Investment Services (RIS). The objectives of the study were twofold: to obtain survey and experimental evidence regarding both the individual behavioural traits and the external factors most influencing consumers' decision-making

SEC(2010)1257 The Consumer Markets Scoreboard 4th Edition October 2010

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Consumer Decision-Making in Retail Investment Services: A Behavioural Economics Perspective

in RIS; and to explore the effectiveness of different policy remedies in helping consumers make better decisions. 2 4. Structure of Report

This report is divided into two main parts, corresponding to the two phases of research involved in the project: review (first phase) and experiments (second phase). The first phase had four components: a review of the BE literature; a review of the retail investment market; a consumer survey of the retail investment purchase process; and an assessment of policy options. The second phase consisted of three experiments that investigated specific aspects of retail investors decision-making processes and the impact of potential policy interventions. Each chapter reports the findings and conclusions of the following component of the research: Chapter I: provides an overview of the project and a summary of the main findings and conclusions. Chapter II: surveys the literature from fields such as BE and Psychology, to review the available evidence on consumer decision-making in retail finance and to highlight the behavioural biases most likely to lead to consumer detriment in these markets. Chapter III: describes the structure of the retail investment market in twelve different EU Member States and briefly analyses a small sample of retail investment marketing material from across the EU. Chapter IV: reports the findings of an online survey of 6,000 consumers in eight EU Member States, concerning the process of researching, choosing and purchasing a retail investment product. Chapter V: summarises the available evidence on consumer decision-making in the retail investment market; describes the current regulatory regime and the range of available policy options; and prioritises decision-making biases and potential remedies for experimental testing. Chapter VI: reports the findings of an online experiment with 6,000 subjects in eight EU Member States, exploring peoples decision-making capabilities in

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Consumer Decision-Making in Retail Investment Services: A Behavioural Economics Perspective

simple unadvised investment choices and the impact of a range of policy interventions on decision quality. Chapter VII: reports the findings of a second online experiment with 6,000 subjects in eight EU Member States, exploring peoples response to the disclosure of conflicts of interest in stylised advised investment choices and their willingness to pay up-front fees for information and advice. Chapter VIII: reports the findings of a laboratory experiment with 480 subjects in three EU Member States, exploring the impact of direct communication between advisor and advisee upon the efficacy of disclosing conflicts of interest and upon the trust people place in advice. Chapter IX: summarises the experimental findings and assesses the implications for policy makers, as well as suggesting future directions for further empirical experimental research to support policy decisions. 3 5. Summary of Review Findings

Our review of the existing literature on BE focuses particularly on issues relevant to the European (as distinct from the US) investment market. In addition to the familiar behavioural biases that we identify as potentially relevant in the retail investment market, a distinctive feature of this review is that it identifies the importance of a range of cognitive and social biases that play a role in consumer investment decisions when assisted by an advisor or salesperson. For example, we place considerable emphasis on processes of persuasion, the importance of personal interaction, and the role of trust. Some of the key findings of the review are: A growing body of evidence shows that the standard model of a rational self-interested economic agent does not adequately describe human decision-making. The formation of beliefs is based on the perception of circumstances, so it can be context-dependent and subject to framing effects or biases such as overconfidence. Preferences may be reference-dependent and inter-temporal preferences can be subject to biases such as short-sightedness or procrastination. Cognitive limitations

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Consumer Decision-Making in Retail Investment Services: A Behavioural Economics Perspective

can lead to a reliance on heuristics, and people are often averse to ambiguity as well as uncertainty. Features of the retail investment market may make consumer decisions particularly prone to biases and errors. Evidence suggests that many people - especially the younger and less educated - do not possess a sufficient level of financial knowledge and understanding, while evidence on the success of financial literacy programmes is limited. Retail investment products are inherently risky and often involve long time horizons. The market is characterised by a wide array of products with complex pricing structures. Consumers do little searching and instead typically rely on the advice of a professional advisor or salesperson. Consumers reliance on advice makes issues of trust and persuasion of key importance in the retail investment market. Generalised trust, trust in advice and trust in consumer rights can all influence peoples willingness to hold risky assets. Personal interactions may enable an advisor to persuade or influence an advisee, for example by inducing positive emotions, and some consumers may be particularly compliant in the presence of perceived expertise. Disclosing conflicts of interest may undermine trust in advice and give advisors moral licence to act only in their own self-interest. 6. Our review of the retail investment market in the EU draws together publicallyavailable data and existing comparative studies in order to provide an overview of retail investors behaviour across twelve EU Member States. In particular, where data is available, we describe for each country what kind of assets investors choose to allocate their savings to, and through which retail channels those investments are typically purchased. While there are some commonalities across the countries we survey - such as pension wealth forming a large part of households total wealth or the relatively low share of wealth held in risky equity investments - there are also large differences between countries in overall saving and borrowing rates, as well as in the composition of households financial portfolios. A small sample of retail investment marketing materials from eight countries was analysed in terms of its content, suggesting that such

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Consumer Decision-Making in Retail Investment Services: A Behavioural Economics Perspective

material primarily reminds consumers of the need to invest and attempts to convey expertise, rather than communicating specific detailed information about risks, returns and costs. We find no strong evidence for a prevalence of misleading claims or use of framing effects relative to other product markets. 7. Our online survey of 6,000 consumers in eight EU Member States describes the decision-making process followed by recent purchasers of retail investments, as well as exploring the main differences between purchasers and non-purchasers of retail investment products. Some of the key findings of the survey are: Consumers are often confused about the true nature of their investment. In particular, investors, especially purchasers of pensions and structured products, are often uncertain whether or not they are exposed to the risks of stocks and shares. Nearly 40% of investors in stocks and shares (wrongly) believe their initial investment is protected. Although investments are usually triggered by a change of life circumstances and not marketing, information search is very limited. Only around 33% of investors compare investments from more than one provider or consider more than one product from a single provider. Just 27% of investors shop around to get the best deal. Advice is ubiquitous in the retail investment market. Nearly 80% of investments are made in a face-to-face setting, usually with an employee of the investment provider or a professional advisor. 58% of investors say their final choice of product was influenced by an advisor, while the advisor initiated the purchase on a quarter of occasions. Trust in advisors is high, but consumers are often unaware of potential conflicts of interest. The majority of investors mostly or completely trust the advice they receive, and do not perceive their advisor to be biased. Conflicts of interest are often only verbally disclosed, if at all, and most investors disregard the information or do not think about it.

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Consumer Decision-Making in Retail Investment Services: A Behavioural Economics Perspective

8.

In light of all the above findings, and after considering the current EU regulatory regime as well as options for policy interventions, the following issues were chosen as priorities to be addressed in the experimental phase of the research: 1. How capable are consumers of making appropriate choices between investment products in the absence of advice? To what degree are their choices influenced by behavioural biases? To what extent can policy interventions improve the quality of retail investment decisions? 2. Do consumers respond appropriately to the disclosure of conflicts of interest? Does the format of disclosure matter and which is most effective? Does disclosure of conflicts of interest undermine trust in advice? Would consumers be willing to pay an up-front fee for advice? 3. How does direct interaction between advisors and advisees influence investors decision-making? Can free communication enable advisors to persuade or pressure advisees to make certain choices? 4 Summary of Experiment Findings

9.

Our first experiment was conducted online with 6,000 subjects in eight EU Member States. It addressed questions related to cognitive and behavioural factors in nonadvised retail investment decisions. Some of the key findings are: People struggle to make optimal investment choices, even in very simplified investment tasks. Only 56% of funds were invested optimally, with 25% of investment decisions being completely optimal and only 1.4% of subjects making all five investment choices optimally. Older, female, less educated and less numerate subjects made worse decisions. Investment decisions are prone to biases and framing effects. Subjects made worse investment decisions when the optimal choice was harder to understand (fees framed as percentages, annual returns not compounded over the duration of the investment), and they were disproportionately averse to uncertainty (risky investments), ambiguity (incomplete information) and product complexity (structured products).

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Consumer Decision-Making in Retail Investment Services: A Behavioural Economics Perspective

Simplifying and standardising product information can significantly improve investment decisions. Standardising and reducing the amount of information provided helped subjects identify the optimal choice between similar investments. Providing comparable pre-calculated information on the net expected value of each investment helped subjects identify the optimal choice between dissimilar investments.

10.

Our second experiment was also conducted online with 6,000 subjects in eight EU Member States. It addressed questions related to cognitive and behavioural factors in advised retail investment decisions. Our third and final experiment was conducted in the laboratory with 480 subjects in three EU Member states, and addressed questions related to social and behavioural factors in advised retail investment decisions. Both experiments addressed the issue of disclosing conflicts of interest, in different formats and in different settings. Some of the key findings are: The impact of disclosing conflicts of interest is context-dependent. Online subjects hardly responded at all to disclosure. Only those subjects who took more time over the decision reacted appropriately and even then only when the disclosure was flagged in a bold red font, for the simplest of decisions. In contrast, laboratory subjects exhibited a strong reaction to the disclosure of biased incentives, showing evident mistrust of advice. Full and transparent disclosure or a health warning may be necessary for people to understand the implications of a conflict of interest. Online subjects, who were only told that their advisor was paid a commission, did not react to this disclosure unless it was accompanied by a health warning. Laboratory subjects who were told the exact details of their advisors remuneration structure responded to disclosure without such a warning. Disclosing conflicts of interest elicits a knee-jerk reaction that can be harmful as well as helpful. Subjects exhibited contrarian behaviour in their investment choices when biased incentives were disclosed. This led to better decisions when the advisors and advisees interests were adversely aligned but worse decisions when their interests were aligned.

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Consumer Decision-Making in Retail Investment Services: A Behavioural Economics Perspective

Subjects lost trust even when an advisor with misaligned incentives was not actually able to deceive them, showing that their reaction is reflexive. Direct interaction enables advisors to exert (limited) additional influence on advisees. Free communication between advisor and advisee tended to mitigate the knee-jerk loss of trust resulting from disclosure of a conflict of interest. There is evidence that free communication enables advisors to exploit advisees existing biases but not to de-bias them. A significant minority of people may be disproportionately averse to paying an up-front fee for advice. Between twenty and thirty percent of the online subjects displayed evidence of narrow framing and loss aversion making them excessively averse to an up-front fee. There was no strong socio-demographic or attitudinal signature for this group of people. 5 11. Conclusions and Recommendations

The findings of our experimental research shed light on retail investment decisionmaking and provide a detailed insight into the factors influencing consumer behaviour in this market, as well as the relative impact of some of the policy remedies available. Arguably, experimental evidence alone cannot justify regulatory interventions in a market, as a clear market failure must be identified with empirical real-world evidence. Furthermore, any proposed policy action to correct a market failure should ideally undergo further testing in more realistic (although less controlled) settings in order to assess the likely real-world impact and to determine the best way in which to implement the details of the policy. Greater use of such testing would improve the design of policy initiatives, given that the research shows that small practical details can have a significant effect on consumers. Nonetheless, our findings do point towards certain future directions for policy making and for policy research: 1. Simplification and standardisation of product information enables consumers to make better quality investment decisions, at least in our simple choice tasks. Providing pre-calculated and directly comparable relevant information about investments enables better choices between dissimilar options, e.g. across product classes. These principles and ideas

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Consumer Decision-Making in Retail Investment Services: A Behavioural Economics Perspective

could be applied to current and future work on information disclosure, such as the Key Investor Information (KII) document. 2. If disclosure of conflicts of interest, such as commission payments to advisors, is mandated then further testing should be conducted to determine the best form and format for disclosure. Our findings point to the need for either full disclosure or an accompanying health warning to ensure the implications of disclosure are understood. Policy makers must also be careful not to simply elicit a knee-jerk loss of trust in advice that may not be in consumers best interest, especially given their limited capacity to make good decisions without the help of an advisor.

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