Overconfidence: The Trap in Mortgage and Other Financial Decision-Making

Date: 23/03/2011

There was an unexpected increase in the number of Australians falling behind on their home loan repayments during the final three months of 2010.

Ratings agency Fitch's Quarterly Australian Residential Mortgage Performance Report shows that delinquent mortgages rose from 1.3 to 1.37 per cent October to December 2010.

How much time did these home owners put into financial planning... and did they fall prey to overconfidence?

The Australia Institute, a Canberra-based public policy think tank, has examined how Australians approach financial decisions and whether our behavior is typically textbook style in the way that economics and policymakers assume.

Most media commentary is based almost exclusively on 'orthodox' (neoclassical) economics. Behavioural economics draws completely different conclusions about consumer behaviour because while orthodox economics makes assumptions about how consumers should behave, behavioural economics seeks to focus on how consumers do behave.

Orthodox economics begins with the assumption that most people behave 'rationally' the majority of the time. Behavioural economics seeks to identify common patterns of behaviour and then provide possible explanations for these patterns.

Categories of consumer financial behaviour based on behavioural economics models

Consumer type	Definition	% of population
Overconfident	People who say they are better than average at making good financial decisions but whose self-reported behaviour suggests otherwise (eg carry a credit card debt)	28%
Overwhelmed	People who admit to being below average when it comes to coping with their finances or who say that it's too hard to figure out whether they are getting good value out of items such as their mobile phone plan.	18%
Playing catch-up	People who don't pay their credit card off in full each month and who say they still use their credit card to pay essential bills each month.	30%
Oblivious	People who are unconcerned or unaware about things such as whether they could get a better deal on their mortgage, phone plan or pay lower banking fees.	41%
Eternal optimists	People who took out a home loan without considering the possibility of losing their job or getting sick.	44% of people who took out a mortgage recently
Compartmentalisers	People who have a credit-card debt and simultaneously hold money in a savings or redraw facility.	14%
Spending hawks	People who have a budget and entirely stick to it.	6%
Human calculators	People described by economists as 'rational'. They seek out relevant information, know that they are paying low prices for their utilities and mortgage and are not compartmentalisers.	22%

One of the most interesting findings emerging from the survey evidence is that while consumer behaviour is diverse, household income is not one of the main determinants of the behavioural categories.

While those who have experienced financial hardship in the last 12 months are much less likely to be 'human calculators' or 'spending hawks', the same is not true for low-income earners. Indeed, although low-income earners are more likely to have been unable to pay their bills in the past 12 months than the community as a whole, a substantial percentage of high-income households (15 per cent) also experienced financial difficulties.

There is no doubt that those with more money have more options and better access to short and long-run finance than low-income earners. However, the majority of low-income earners report being able to meet their financial obligations while a significant minority of high-income earners cannot.

It would seem, therefore, that a major determinant of financial hardship is the way that individuals make their financial decisions, rather than their socio-economic situation.

One of the major causes of financial stress would seem to be overconfidence.

The survey results show again and again that when asked to rate their relative ability in relation to financial decision-making, far more people believe they are above average than below average - both in knowledge ('understanding everyday financial products) and in behaviour ('making good financial decisions').

1) Try to be realistic rather than optimistic about your financial knowledge and skills.

2) Develop a budget and try to stick to it.

3) Spend time shopping around for savings on regular expenses such as mobile phones and electricity, even if this is confusing or tiresome.

4) Pay off your credit card debt as quickly as you can, and avoid the temptation to 'stock up' on items that are on sale.

5) Don't compartmentalise your finances in such a way that you simultaneously pay high interest on credit cards while earning (or avoiding) low interest on savings accounts (by being in advance on your mortgage).

6) Don't be influenced by financial institutions about how much you 'could' borrow; the fact that they are willing to lend it doesn't mean that you will feel comfortable repaying it.

7) If you get into financial trouble, ask for help sooner rather than later.