Research shows that most people underestimate the chance of a negative event and overestimate the chance of a positive event happening to them.
This is called Optimism bias as it results in us having an unrealistically optimistic view of the future. For example:
- although about half of Western marriages end in divorce, few people getting married think it may happen to them; and
- we underestimate our chance of being in a car accident, partly because we overestimate our driving ability.
This is widely regarded as the reason so many large projects go so badly wrong. The UK government says project plans should allow for optimism bias by increasing the costs and timescales projected. It’s not just a public sector problem – the Channel Tunnel opened a year late at a cost of £10bn – more than twice the original budget.
These cost and time over-runs are known as the Planning Fallacy and they apply to personal plans as well. I am sure I can write this article in a couple of hours, despite the fact that I know it usually takes a day… And even though I know I expected to complete the previous articles in a couple of hours and failed, I still think this article will be quicker.
Here I am interested in the effects of optimism bias and the planning fallacy on borrowing and debt solutions.
The optimism bias and borrowing decisions
Debt advisors see the casualties of their clients’ having been over-optimistic when taking out credit. This applies to “cheap” credit as well as poor decisions about high-cost credit when someone’s situation has got worse.
- Klarna-style pay later products are sold as the simple way of trying on and only paying for clothes that fit and suit you. Except that people keep more than they intended and are over-optimistic about their ability to pay in full before the 0% period ends, so they end up paying expensive interest;
- a couple do up a house on credit cards, not considering the effect of a child on their finances, let alone separation, illness or redundancy;
- someone who continues to take ever higher cost credit in order not to default on existing borrowing “because they will want a mortgage soon”;
- someone who consolidates debt for the second time, despite the fact it didn’t work the previous time.
The planning fallacy and debt solutions
The optimism bias doesn’t stop when a client gets debt advice. And when the timescale for getting out of debt is many years, the planning fallacy is important.
- Mr Micawber’s “something will turn up” reason for not opting for a DRO when you can only make token payments;
- “I would rather have a nine-year DMP than an IVA” which ignores all the reasons a nine-year DMP could turn out to be much longer in practice;
- “I think paying £75 a month in an IVA will be fine because it’s a lot less than my current debt repayments” which ignores all the reasons a low Disposable Income IVA may fail. But it is hard to say this is in any way the fault of the client when the IVA firm does not tell them its IVA failure rate is 31% [or whatever the number is for that firm].
Very hard to overcome these biases
The evidence from psychology research is that it is very hard to counteract the optimism bias and planning fallacy. Providing accurate statistics about what has happened to other people in similar situations often seems to make little difference.
One possible reason for this is confirmatory bias. People are much keener to read and take notice of facts that confirm what they want to do rather than facts that point in the opposite direction. Someone thinking about a consolidation loan may be more interested in success stories than people pointing out the pitfalls.
Another explanation is that people tend to over-estimate the amount of control they have over what happens to them. So most smokers think they are less likely to get cancer than the average smoker. In taking out credit or choosing an IVA, many people will think they can manage the monthly payment because their budget will be under their control, ignoring factors such as inflation, employment problems, family changes etc.
It’s worth noting the positive side of optimism. One of the barriers to taking early debt advice is the gloomy feeling that nothing can be done about someone’s debts. Confidence is good if it helps someone take positive steps to deal with their situation.
Some implications for debt policy and advice
1. Facts are good
Important facts should be presented to people at an early stage in the decision-making process and in a prominent way.
If someone has already decided they will be a guarantor telling them later, or in the small print, that 15% of guarantors have to make some payments where the borrower can’t [or whatever the actual figure is for that lender], may be too late to change their mind.
It is one of the biggest problems with lead generators – regulated and unregulated – that they may give biased advice. This then causes people to be optimistic that an IVA is an answer to their debts. The Insolvency Service and the FCA need to ensure this does not happen.
2. Warnings alone are not enough where the detriment is high
Where regulators can see significant problems with poor decision making, providing facts alone will not always correct this.
I was pleased when the FCA changed its mind about Buy Now Pay Later catalogue deals and will now ban the charging of backdated interest on settled amounts. This practice was so unfair and so complicated to explain that no amount of warnings before someone took this credit could have been sufficient to counteract the tendency for buyers to be over-optimistic about their ability to repay within the term.
I also see considerable harm arising from guarantor loans. The FCA has said it will be considering whether guarantors have sufficient information about how often guarantors have to make payments. I think they don’t at the moment, but this is only part of a much wider problem about guarantors lacking adequate information to take an informed decision.
3. Debt advisers have to advise on the best option
It’s not a debt adviser’s job to take a decision for a client. But it’s not TCF to let a client take a poor decision without explaining in detail why another option would be better.
So if someone says they don’t like the sound of bankruptcy, and they have no assets to protect or a job that could be affected, a debt adviser should spend time debunking the myths about bankruptcy and point out the high costs and failure rate of IVAs.
4. Robo advice & Open banking – caution needed
One of the dangers of using robo-advice – a program that asks a client about their income, expenses and debts and suggests which debt solution may be appropriate – is that a client’s expectations may be coloured by what the tool said. Most people want to be presented with an easy solution and may then be over-confident that the selected one will work for them.
Similarly with Open Banking – if an Income & Expenditure can be generated instantly based on the client’s bank transactions, the client may feel over-confident that the proposed monthly payment in a DMP is going to be affordable.
So although it’s good if there are ways to make the debt advice process more efficient, through robo-advice at the start or using open banking, we need to be careful that enough time is given to exploring with the client why these snapshots of the past may not be accurate and what may change in the future. Otherwise these potentially impressive tools could lead to bigger problems with clients and Optimism bias.
PS I started this article yesterday morning.
There were unexpected reasons why it took so long to finish.
I’m sure the next one won’t…