Household finance is a relatively new field of study that aims to develop a better understanding of how people make financial decisions. Its relevance and distinction from other fields of economics were highlighted by Harvard economics professor John Campbell in his 2006 presidential address to the American Finance Association: ‘The study of household finance is challenging because household behaviour is difficult to measure, and households face constraints not captured by textbook models’ (Campbell, 2006).
It is questionable whether the lessons from this new field have been reflected to any great extent in the way that the banking and financial services industry works. Yet they should be: a better understanding of how and for what purposes people spend, save, invest and hold assets can act as a springboard for action by the industry to help consumers.
Working with the Household Finance Network of the Centre for Economic Policy Research (CEPR), the Think Forward Initiative (TFI) is seeking to build a bridge between research and action. The TFI approach is to develop a deeper understanding of what drives people’s financial decision-making and to harness those insights to help them make better decisions – ‘economics in the service of society’.
To signal the burgeoning relationship between researchers and practitioners, summaries of key research papers in household finance were presented at a conference in London in September 2016. Five prominent European economists outlined the implications of their research for understanding households’ financial decisions.
- The differences in how households in different countries hold total wealth.
- The effect of differing levels of financial education on decision-making.
- Variations in the marginal propensity to consume.
- Differing risk appetites by income level.
- Income inequality and exposure to investment risk.
What prevents people from accessing financial products
One key issue for financial institutions to understand is the wide range of impediments that prevent households from taking up opportunities to invest, save and borrow in ways that fit their needs. Professor Michael Haliassos of Goethe University Frankfurt, the director of CEPR’s Network on Household Finance, has explored the impact of people’s individual characteristics, the economic environment in which they find themselves, their cultural predispositions and the influence of neighbours and peers.
One of his studies documents international differences in ownership and holdings of stocks, private businesses, homes and mortgages among older households in 13 countries (Christelis et al, 2013). As might be expected, households’ financial behaviour is influenced by such personal factors as their gender, educational attainment, occupational status and position in the country’s income and wealth distributions.
But controlling for these characteristics, there is also considerable variation in financial behaviour across countries, which can be attributed to differences in national institutions, markets and policies. For example, before the global financial crisis, US households tended to invest more in stocks and less in homes and to have larger mortgages than Europeans with similar characteristics. At the same time, differences in economic environments and household financial behaviour are more pronounced among European countries than among US regions.
Cultural predispositions seem to play an important role here. Another study, which compares the financial behaviour of Swedish natives and immigrants from a number of different European countries, uncovers differences across cultural groups in how financial behaviour relates to household characteristics (Haliassos et al, 2016). But the evidence also suggests that such differences diminish with increasing exposure to host country institutions, even for immigrants from countries with significant cultural distance from Sweden.
Households’ relative standing among their neighbours and peers also matters for financial behaviour. For example, a further study analyses Dutch data on people’s social interactions, in particular their perceptions of the incomes of households in their social circle (Georgarakos et al, 2014). It shows that those who consider themselves to be poorer than their peers are more likely to borrow ‘to keep up with the Joneses’ and, as a result, to find themselves facing financial distress.
Can improved financial literacy make a difference?
What can be done to boost households’ participation in suitable financial products? One potential response is to improve financial literacy, an area that has been the focus of a series of studies by Professor Tullio Jappelli (University of Naples Federico II and CEPR). He notes the extensive evidence that a large proportion of adults in most countries are unfamiliar with even the most basic economic concepts, such as inflation, risk and mortgages. Such low levels of financial literacy can be blamed for people’s poor financial decisions, with knock-on effects for the wider economy.
But it is also clear that there is considerable variation in financial literacy across countries (Jappelli, 2010). For example, people in countries with higher levels of educational achievement tend to be more financially literate; those in countries with more generous social security systems are generally less financially literate. What’s more, countries where there is higher financial literacy have higher saving rates and greater wealth (Jappelli and Padula, 2011).
Financial institutions can clearly play a role alongside public policy-makers in improving a country’s financial literacy. There is also the possibility of making use of the social interactions that influence financial behaviour. The study of natives and immigrants in Sweden by Professor Haliassos and colleagues reveals that having access to financially literate neighbours with some university education increases a household’s likelihood of saving for retirement and investing in stocks (Haliassos et al, 2016).
There is also evidence that households’ lack of familiarity with financial products from which they could benefit can be mitigated by a knowledgeable financial services industry with appropriate incentives. When East Germans who had been deprived of ‘capitalist’ financial products were provided with the same opportunity to use them as their West German counterparts following the reunification of Germany, they participated immediately, were as likely to invest in unfamiliar risky securities and more likely to use consumer debt (Fuchs-Schündeln and Haliassos, 2015).
How households respond to income changes
If a household’s income changes, what happens to consumption and what happens to ‘precautionary saving’ – money put aside for a rainy day? And does it make a difference if the change in income is expected or unexpected, temporary or permanent, a decline or an increase?
Answers to these questions about the marginal propensity to consume are potentially of value both for the financial services industry looking to understand household behaviour and for governments aiming to design effective fiscal policies. Professor Jappelli has explored them in a series of studies (Jappelli and Pistaferri, 2010, 2014).
This research reports considerable evidence that household consumption responds to anticipated income increases by more than what is implied by standard economic models of ‘consumption smoothing’ over people’s lifecycle. For example, households that are less likely to be able to access credit markets typically have a higher marginal propensity to consume. But consumption by all households is much less responsive to anticipated income declines, for example, after retirement.
A second finding is that the consumption reaction to permanent income changes is much higher than that to transitory changes. But at least in the United States, households do not revise their consumption fully in response to permanent changes.
Taken together, these findings suggest that precautionary savings play an important role in consumption. They also indicate that tax changes might have a considerable impact on consumption expenditures, though the precise effect will depend on whether the policy is anticipated, whether taxes increase or decline and whether the change is perceived as temporary or permanent.
Household decisions about savings and investment
Households save for several different reasons, including retirement, rainy days, big planned purchases, such as property or children’s education, and wanting to bequest something to the next generation. As research by Professor Francisco Gomes (London Business School and CEPR) makes clear, the relative importance of these different savings motives changes with age, which makes it valuable to analyse what he calls people’s ‘lifecycle portfolio choice’ to determine the best assets in which to put their savings (Campanale et al, 2015).
The optimal portfolio allocation will vary across households since there are inevitable differences in their tolerance of risk, their other sources of income, notably from the labour market, other sources of risks, such as health and mortgage debt, and how all these risks correlate with the returns to different portfolio assets. The key insight is that these factors change with age, which means that the optimal portfolio allocation should not be remain constant over the lifecycle.
In a comparison of the changing financial product needs of households over time with ‘lifecycle funds’ and other retirement solutions that are actually available in the marketplace, the research finds big differences. For example, funds typically fail to take account of the higher risks that people face early in their working lives. This means that their exposure to stocks should not start high and decrease gradually into retirement: rather, it should be a hump-shaped function of age. Professor Gomes calls for funds and financial advice that are flexible enough to match the needs of different investors.
Wealth inequality and financial behaviour
A further influence on households’ financial behaviour is their position in the wealth distribution and whether there is a national trend in the direction of higher or lower wealth inequality. Professor Laurent Calvet (HEC Paris and CEPR) has examined whether wealthier households earn higher returns on their investments and, if so, why.
Analysis of data on all residents of Sweden shows that returns to the gross and net wealth of the top 1% of households are 4% higher per year than those for the median household (Bach et al, 2015). These higher returns are not driven by exceptional skill or private information but by the wealthy being able to take on greater exposures to risk. Similarly, the Swedish middle classes earn high returns on their net wealth, primarily by taking leveraged positions in property. Both outcomes serve to amplify wealth inequality.
Professor Luigi Guiso (Einaudi Institute for Economics and Finance and CEPR) has also explored variation in the returns to wealth depending on where households are in the wealth distribution (Fagereng et al, 2016). Using data on tax returns and wealth holdings for the whole Norwegian population, this study finds further evidence that wealthy investors can be more tolerant of risk. The higher returns that wealthier people enjoy also have an element of greater financial sophistication, either on the part of the wealthy themselves or in their ability to buy the services of experts.
Another study by Professor Calvet has considered the characteristics of financially sophisticated and unsophisticated households (Calvet et al, 2009). Again looking at the comprehensive data on Swedish households, the research focuses on three investment mistakes: portfolios of assets that are insufficiently diversified; resistance to risk-taking and the higher returns it offers over the longer term; and the tendency to sell winning stocks and hold losing stocks (‘the disposition effect’).
Perhaps unsurprisingly, wealthier households have greater financial sophistication and tend to avoid these investment mistakes. Household size also plays a significant role – the more children, the more sophisticated the finances – while education and financial experience are less important.
Overall, this study indicates that people are much more careful in their financial decision-making when they understand that the outcomes will make a real difference to their lives: for example, when they have children, when they have some wealth and when their education offers the prospects of future wealth. There are clear lessons for financial institutions seeking to help their customers make better financial decisions. Of course, consumers, governments, NGOs and others can also build on these insights. The Think Forward Initiative aims to take this wider social perspective.