Many people are struggling financially. Figures from the Money Advice Service and DWP show that half of people say that they are worried about their finances, four in 10 people say that they could not easily cover an unexpected bill of £300, and 40% working age people in the UK face inadequate incomes in retirement. Feeling out of control of your finances can be stressful, and a lack of buffer can leave you vulnerable when faced with unexpected expenses.
In this context it’s no surprise that people are calling for more financial education, but this might be missing the essence of what is really needed. To ride a bike you have to a) keep your balance, b) place your feet on the pedals and simultaneously exert force, and then c) steer to avoid crashing. But knowing these things is very different from knowing how to ride a bike. The former does not necessarily lead to latter.
The same could be said about budgeting. Knowing that a budget should list all your income and your outgoings is different from preparing a real budget for yourself that you use to inform your financial decisions. The distinction might seem subtle, but it is important. To teach concepts in the abstract, simply providing more information might be enough; but to teach a skill requires a lot more, and financial education could up its game accordingly.
In a paper published recently by the RSA, we discuss this practical nature of financial capability, review how our psychological dispositions can undermine it, and explore how it should be taught.
The psychology of financial capability
Readers of this blog will know that research from behavioural science shows that despite good intentions, our efforts to achieve a given goal can be systematically undermined in a variety of ways. The same is true for financial capability, and based on a large body of existing research, we identified ways in which our own natural thinking patterns can make it difficult to manage money well both day-to-day and in the long term. We call them the six behavioural hurdles to financial capability:
- Cognitive overload. Having a lot on your mind impairs decision-making, and tends to result in selecting the simplest option – which is not necessarily the best one. So if you have a big deadline at work looming, some unexpected out-of-town visitors at your door, one sneezy child and another one with an upcoming dance recital, and the boiler breaks, this is not a good time or a good context to review your pension investments or pick a new phone tariff.
- Empathy gaps. Overlooking how you might feel in a different situation can result in unnecessary purchases, such as overbuying when shopping for food on an empty stomach. One part of us acts as if a stranger to other parts, and the empathy gap between present self and future self is particularly common and acute.
- Optimism and overconfidence. Wearing rose-tinted glasses and having unrealistic expectations about the future can affect money management and leave you unprepared for a change in circumstance.
- Instant gratification. Seeking instant gratification drives impulsive spending and can undermine long-term planning and savings.
- Harmful habits. When something becomes a habit it can feel like it happens automatically or mindlessly. This means there’s no consideration of whether you really want to do whatever the habit is (and there’s certainly not a careful cost-benefit analysis), so habits can lead to unnecessary spending.
- Social norms. We are heavily influenced by the actions of others, which can cause pressure to keep up with the Joneses and live above our means. Spending and consumption norms are often visible – think of a new phone or the latest fashion. But activities like contributing to a pension or taking out insurance plans are less visible and therefore less catchy.
It could be argued that the psychological traits above are just a cute sideshow and the real focus should be on the economic or political drivers of poor financial wellbeing. It is critical that these drivers are not ignored. However, these behavioural hurdles exist whatever the economic and political situation. They’re not going anywhere, and given that more and more financial decisions are devolved to us as individuals, they may be even more burdensome. So we owe it to ourselves to provide financial education about these behavioural hurdles that develops strategies to work with them, to help ride out the waves whatever the weather.
Shaping financial education to improve capability
So what can we do? As a start, we can design financial education, policy and products with these behavioural hurdles in mind. Financial education providers should review the six hurdles and teach people strategies to work with them. For example, if cognitive overload plays heavily in your life, set up automatic reminders or direct debits to avoid missing bill payments. Or in the example above, where a decision doesn’t have to be taken immediately, delay it until you have some head space or get a second opinion from a trusted friend.
Another key recommendation for financial education providers is to use simulations or other learning-by-doing techniques so that skills can be practiced. Additionally, financial education should be provided early on in life, and reinforced before key financial decisions need to be made, for example before a wedding or before moving into independent housing. And above all, more evaluation is needed to pinpoint what exactly works best in financial education for a given context.
They say money talks. But for financial capability, research shows that the issue is not talking the talk, the real challenge is walking the walk.
Nathalie Spencer is a Senior Researcher at the RSA.
She is co-author, with Jeroen Nieboer of the LSE and Antony Elliot of the Fairbanking Foundation, of Wired for Imprudence: behavioural hurdles to financial capability and challenges for financial education which is available for free download.
A version of this article was previously published on the RSA website and on the Money Principal blog, under the title: The psychology of financial capability and what it means for education.
Image is copyright RSA, and was designed by Karoshikula.