• by Tanya Gazdik , July 17, 2013

Researchers find that financial decisions are influenced more by people's subjective feeling of how much they know than what they actually know about potential investments, according to a new set of studies.

A paper that appears in the June 2013 issue of the American Marketing Association’s Journal of Marketing Research shows that people are more likely to choose investment options that they feel they understand better, regardless of how much they actually know about them.

An increasing number of new and complex financial products are making financial decisions more difficult. Research indicates that people often make poor financial decisions as a result.

For example, people tend to under-diversify their investment portfolio -- thereby exposing themselves to greater risks, as they fail to save enough money for retirement, or to use tax benefits efficiently.

Governments, employers, and financial institutions have begun to engage in financial education efforts, assuming that people will choose better if they are better informed concerning available options. Unfortunately, there is no evidence that financial education succeeds in improving financial decisions.

The studies suggest that what's most important in financial decisions is not what we know about the available options, but how knowledgeable we feel about them. 

For example, in one study participants chose between two Life-Cycle Funds (funds that gradually shift their balance from stocks to bonds), where one fund was riskier than the other, and each fund was described in basic or more complex terms. The researchers found that when both funds were described at the same level of complexity, or when the low-risk fund was described in simpler terms than the high-risk fund, most participants preferred the low-risk fund. The pattern reversed when the low-risk fund was described in more complex terms.

Financial educators will better serve consumers if they ensure that the financial information they provide does not impede consumers' feeling of knowledge, but rather enhances it.

"Despite the massive resources allocated to financial education, these programs often backfire because the information they provide is often presented in ways that make consumers feel confused or intimidated and thus deters them from investing," said Liat Hadar, an assistant professor of marketing, Arison School of Business, Interdisciplinary Center Herzliya. "Financial education efforts would be more effective if they present only the essential details concerning relevant investments in ways that are easier for consumers to understand."  

Joining Hadar in this research were Sanjay Sood, an associate professor of marketing, Anderson School of Management, University of California, Los Angeles; and Craig Fox, a professor of strategy, Anderson School of Management, and Professor of Psychology, Department of Psychology, University of California, Los Angeles.

"Open door diversify investments" photo from Shutterstock.