Most Aussies know that Australia is a nation laden with debt.
Just days ago on Jan 2012, News reported that 2.2 million Australians don't pay their credit card balance in full. As a nation, we owe about $50 billion in credit card debt. Meanwhile, we also owe an average of $271,000 in mortgage – and it's not like we are taking it easy. According to the report, mortgage repayments are,on average, consuming 27% of household income – just 3% away from the definition of "mortgage stress".
And if you're a student, your debt doesn't end there. The average Aussie student owes an additional $15,000 in student debt – forecasted, like any other debt, to massively increase in the next few years, as it had in the past.
The problem of over-leveraging, of course, is nothing new. And we are not alone. The US, UK and essentially all other developed countries face the same issue. So the governments of these countries took massive action to stop the trend.
For one, they curbed unfair banking practices and introduced various laws and incentives meant to help the average Joe. Second, they prioritised the importance of personal finance education, introducing it to classrooms across the nation and spending millions educating the general public on how to handle money.
Question is, did all the fuss work?
That's debatable. Even after years of financial education, the debt problem we are facing hasn't improved – not even by a little. In fact, it can be argued that we are living more recklessly today than ever before (except for the brief period of time when the crisis hit). So what went wrong?
How Much Debt Are You In? Guess Again.
In October 2011, four researchers from the Federal Reserve Bank of New York conducted a study on the accuracy of the data other researchers use to come to their conclusions. Specifically, they were looking into how accurate a participant can remember a past event. As you are probably aware, many questions in a survey are about what happened in the past and if participants couldn't even recall them, then these self-reported numbers couldn't be trusted.
Now, you would think that with all the problems debt caused in our lives, we would be acutely aware of just how much we owe. But that's not what these researchers found.
When asked to recall how much debt they are in (which are then compared to official numbers), households reported the right levels of mortgage loans, student loans and even bankruptcies. When it comes to credit card debt, however, only 50% of households reported they have it, even though credit card companies reported 76% of households owed them money. Even those who reported they have credit card debt reported 50% less than what financial institutions claim they owe.
Perhaps those who religiously pay off their balance each month didn't see the amount they owe as "debt"? The researchers corrected for those instances – and a few other potential discrepancies – but still, the numbers didn't match.
Why is that? The researchers explored a few explanations and concluded that the explanation is simply "wilful ignorance". That is, people don't want to know how much debt they are in. Various surveys conducted since came to the same conclusion. Popular personal finance blogger, RamitSethi, for example, asked his readers how long they would take to get out of debt and 34% said they don't know.
So why don't people want to face the situation they are in?
When it comes to huge societal problems, it's intuitive to start with raising awareness. Al Gore, for example, filmed his now-famous documentary, An Inconvenient Truth, for precisely this purpose. The reasoning goes that for something to be done, people first need to care about it. But before they can care, they must first be aware of it.
It's intuitive and it's common sense. Yet as Duncan J Watts explained in his book, Everything Is Obvious When You Know The Answer, our intuition is wrong more often than not.
In questioning this assumption, Steven Shepherd and Aaron Kay conducted an experiment to find out if raising awareness really works. To do that, they recruited48 undergraduates and had them read either simple or complex descriptions of a fictitious energy source. After the students finished reading the descriptions, they were then asked to rate how much they trust the government to manage that energy source.
Complex descriptions, they found, increased trust in government management.
In a series of follow up experiments, Shepherd and Kay began piecing the puzzle together. Far from intuition, ignorance doesn't trigger the pursuit of knowledge. Ignorance actually breeds more ignorance. Instead of trying to close that knowledge gap, the researchers found that ignorant people develop dependence, which in turn develops trust in the government, which then develops avoidance of the issue.
In other words, if the issue is complex, we don't want to understand it – we get the experts to do it for us. We viewed the government as the authority in the issue and entered what psychologists called the "agentic state" – a state of mind in which we pass responsibility of our own actions to the one in command. For example, a soldier is more likely to murder innocent civilians when his general commands it because he rationalised that it's not him who is responsible for the hideous crime – it's his general's.
Societal issues like excessive debt, of course, are never simple. Should we cut down our spending? If everyone does that, won't the economy slow down to a grind? Shouldn't we be trying to achieve more rather than live like a hermit? But isn't excessive consumption the reason we are in this mess? Even the experts are still struggling with the issues.
In raising awareness, therefore, activists are unknowingly pushing the ignorant to depend on a third-party.
And if that's not counter-intuitive enough, get this: the more worrying and the more urgent the issue is, the more people rely on an authority and avoid the issue altogether. The only thing the ignorant did learn from an "awareness campaign" is the positive information that may ease their worries – information like economies work in cycles so things will recover soon. Positive information, of course, will bring about the exact opposite intention of the campaign: inaction.
To the worried,in other words, ignorance is bliss.
So we don't know our credit card's balance. So what?
It wouldn't be a problem if it weren't for the fact that we are also neurologically hard-wired to be overly optimistic. In a series of experiments, researchers have shown that we significantly overestimate the chances of positive events and underestimate the chances of negative events.
For example, 90% of drivers believe they are above-average. Meanwhile, students consistently overestimate how well they will do financially when they graduate. In personal finance, 71% of Americans who indicated they were in control of their finances were optimistic – but feeling in control, the study found, didn't correlate with actually being in control. In fact, feeling in control raised their spending during the holidays.
But we are intelligent creatures, aren't we? We make mistakes, learn from our mistakes, change our behaviour to become a better person, and adjust our world-view. That's what we like to think who we are, yet is really true?
To find out, a group of researchers had 400 fans of the NFL games to make predictions about the chances of their teams winning. These were real fans – they watched at least 4 games a week and owned at least 2 jerseys each. By the end of the season, these fans made at least 14 predictions out of the 17 week season. So what was the result?
Consistent with previous research, the fans were optimistic: they predicted their teams would win 69% of the time, even though on average, their teams won only about 50% of the time. The twist comes when the season ended and the fans were asked to make yet another prediction. You would think the numbers would change their opinions… but despite "accuracy incentives and extensive feedback" (the researcher's own words, not mine), the fans actually made pretty much the same overly optimistic forecast.
That is not to say optimism doesn't have a place in the modern society. For one thing, optimists have been shown to live longer, recover from surgeries faster and even develop lesser diseases. Optimism also allows us to see a better future, and therefore work towards that future. Why would you work hard today if you think the world is going to end tomorrow?
But as Puri and Robinson, authors of a paper titled Optimism and Economic Choice, discovered: there IS such a thing as too much of a good thing.These "extreme optimists" tend to work less, save less and carry balances on their credit cards. In fact, many experts believe that the 2008 financial crisis was caused by supposedly rational analysts who overestimated the future performance of their assets – even when the numbers indicated otherwise.
To be fair, extreme optimists makes up of only the upper 5% of all optimists. But they are not the point of this article. Let's assume for now that you're a healthy optimist (extreme optimists won't identify themselves as extreme anyway). Even then, our instinctual optimistic outlook of life can have a great effect on how we live our life.
For example, psychologists are now aware of what is called "the third person effect" – that is people tend to underestimate the effects of mass media and advertisements on themselves but overestimate its effect on others. According to Edwin Diamond, experts are in fact the ones who are most prone to the third person effect (thus the perceived need for censorship) and that the effect gets stronger if we don't agree with the message.
So what has this got to do with optimism?
Well, as it turns out, unrealistic optimism was identified as one of the potential causes of the third person effect. When we see an advertisement with a negative message, we instinctually try to preserve our positive self and dismissed its message, thinking that that will never happen to us. One study, for example, found that advertisements that emphasise the risks of reckless driving had the opposite effect: people assumed that won't happen to them and therefore drive recklessly.
Putting It Together
What does this all mean to your personal finance?
Well, on the one hand, we have a government trying to educate its people about money and telling them about the dangers of irresponsible credit. On the other hand, there are financial institutions advertising just how happy you'll be if you borrow money to go on a holiday.
Knowing what you know now about the third person effect, can you guess who is winning the advertising war? And that's not even taking into account our unwillingness to learn complex systems. In fact, it can be argued that the more rules the government enact to protect the people against predatory lending, the more likely it is for people to behave irresponsibly.
To understand why that is, let's first look at another area of life with lots of rules: traffic. Conventional wisdom (and the media) dictates that following the rules is the safest way to conduct yourself on the road. But analysis of the numbers found otherwise.
In Chicago, for example, 80% of accidents that happen in a crosswalk happened when the pedestrian has the right of way. In New York, jaywalkers are involved in less traffic accidents than their law abiding counterparts. Meanwhile, a five-year long study in San Diego found that twice as many accidents happen in marked crosswalks than in unmarked ones.
So why is it when the rules are there, accidents increased? According to the researchers, when there are rules, pedestrians became less cautious. Jaywalkers looked left and right before they cross the road. Their law-abiding counterparts, however, cross the road as soon as the pedestrian light turned green, taking it for granted that all cars will also follow the rules.
Perhaps this is why removing clutters like street signs, kerbs, pavements, etc, can actually reduce accidents. The idea was first tested in Holland and it indeed improved safety as drivers became more observant. In one intersection during the test, accidents decreased from 36 in 4 years to just 2 in the 2 years since the traffic lights were removed. Now UK's busy Exhibition Road is trying it out.
Or as Hans Monderman, the original architect of Holland's "minimalist" road said, "A wide road with a lot of signs is telling a story. It's saying, go ahead, don't worry, go as fast as you want, there's no need to pay attention to your surroundings. And that's a very dangerous message."
So are all the rules the government set for financial institutions saying a very different message to end users?
As J.D wrote over the years, the key is not in financial literacy. It's in behavioural literacy and conscious spending. As someone who's only starting to manage my own finances, I try to learn as much as I could, not on financial instruments, but on the psychology that makes me tick.
I'm not saying you shouldn't spend your time learning financial instruments. But I do think that most people skip algebra to study differentiation, metaphorically speaking.
So what are a couple of elementary topics I think everyone should learn? I'm glad you asked. Remember, these are MY lessons so not all of them will apply to you. I learned that…
- It's my personal responsibility to take care of my finances. I know it sounds obvious but ask people why they're not at the financial level they like and they'll tell you any reasons from the bad economy to the evil corporations to the incompetent government. It's just never their fault.
- It's a better idea to underestimate positive yield and overestimate negative ones than vice versa. Sure, perfect information is ideal but trust me when I say that no one on Earth has it. Note: This is not to say that you shouldn't be optimistic. I still forecast for positive yield when the numbers allow.
- Keeping an eye on the numbers do more than just allow me to do an effective budget (and keeping to it). It also keeps me grounded. There are evidence, for example, that people spend more when they use credit cards. According to the report, when McDonald's began accepting credit card payment, the average order size increased from $4.50 to $7.
Does that mean you shouldn't use a credit card at all? That's like saying you shouldn't drive at all because traffic accidents happen. The key, I think, is a subtle balance and balance starts with knowing why using plastic makes you buy more.
The first reason is the one we've explored: because people are not usually aware of how much they owe – and therefore never knew of their limits (have you ever had your card turned down because you don't know you're over the limit? Yeah, me too). The second reason is more subtle: people who use credit focus more on the product's benefits than its cost.
Keeping an eye on the numbers allow me to overcomes both of these reasons.
- If a concept sounds obvious… if everyone seems to "agree" that it's right… I should be very cautious of those concepts. I'd test them. Here's an example: should you really quit buying coffee? Should you really pay everything in cash?
- Advertisements work. I come from a marketing background, and as a professional, I really thought I was immune. After all, I study that stuff and I know, beyond the shadow of doubt, what they are trying to do. Yet I couldn't help it. As it turns out, 95% of our decision making takes place in the subconscious.
So what did I do? I took a radical step to cut out as much advertisements out of my life as possible. I use adblock to block all ads online, I don't watch TV, I don't read newspapers or magazines. For the most part, the only ways an advertiser can get to me are through billboards, product placements or otherwise sponsored content. This is crucial.
Spending, I believe, is directly correlated to exposure to ads. In this GRS post, for example, J.D highlights how just reducing the frequency in which you visit grocery stores can save you big bucks. The idea is not to resist temptation (a subject often discussed by inexperienced individuals). The idea is to remove temptations before it even happens. Well, the same is true with shopping centres, e-commerce sites and advertisements.