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Question 1: How do the concepts of behavioral finance create opportunities for HelloWallet?
The current financial advising sites such as HelloWallet as well as its competitors, such as Mint.com and Yodlee, provide budget and virtual financial advising service based purely on user bank transactions and spending category. The HelloWallet system allows the user to create and track customized budget plan. What is more important is that the system can automatically provide financial advice and saving tips by using data mining techniques.
However, HelloWallet and its competitors do not provide any financial analysis and evaluation based on user behavior and their psychographic characteristics, such as user personality, values, attitudes, interests and risk tolerance in terms of willingness. These psychographic classifications are extremely relevant with regards to individual strategy and risk tolerance. Even with the similar bank transactions data and spending category, an investor background, past experience, personality and attitudes can make investment process unique for each individual. With the help of behavior finance theory, HelloWallet can build system to fit psychographic profiles to specific behavioral investor profile. As a result, a better understanding of user behavioral tendencies of spending and investment will help to provide better financial advice.
An easy and quick way is to build online questionnaire to fit each individual into different behavioral investor types. There are several models we can use, Barnewall Two-way model, Bailard, Biehl, and Kariser Five model and Pompian model. We use Pompian models as an example. The major reason for promoting Pompian is because it is less time-consuming and less complex. Therefore, it will be easy to be implemented on an online system and require less time spent on filling out the survey (as we pointed out in challenge, it is not an easy task to ask online user to fill out survey with a lot of details).
Pompian model identifies four behavioral investor types based on risk tolerance and active/passive scale: passive preserver, friendly follower, independent individualist and active accumulator. It is a top down approach which is more efficient and simple by categorizing users into passive and active, then further break down into four types based on their risk tolerance. With these information, the user of HelloWallet will be categorized based on their investment/spending behavior type. Based on these different types, the system can easily provide more tailored investment tips and products to users. For example, once a user behavior type is identified, the system can provide saving and investment tips accordingly.
For example, when a user is identified to be a passive preserver whose risk tolerance is low and emotional, the system provides low risk financial products (excluding high risk ones), e.g., 2-year GICs. In addition, the system can try to persuade the soundness of these financial by focusing on elaborate the goal of these investment (what the terminate value will be and what type of investors these investments for). If investor specify a long term income need, the system can provide financial products on bond index fit their spending goal (contrary to the current systems which spam non-relevant financial products to all the users without differentiate their needs and risk).
With the introduce of the behavior investor/user types into the systems, HelloWallet can extend their financial advising service from purely creating budget plan and providing saving tips to a more sophisticated investment approach that fits each individual unique needs and background. For example, HelloWallet is currently able to recommend a customer to apply for a visa with $500 cash points per year because excessive spending on grocery and large cash deposit 10,000 in the checking account. With the new behavior investor model, it can recommend the same individual to invest short term money markets products if his risk tolerance is low and require short term liquidity (with a list of the products from different dealer) or it can recommend user to buy equity income mutual fund if their risk tolerance is high and has no need for the cash for the near term.
Another advantage and opportunity for the HelloWallet is that behavior finance is a relatively new concept and traditional financial advisor feel uncomfortable to ask customer these psychological questions face to face. It is much easier for the user to interact with a computer to fill out the questionnaire. This will help to collect more accurate information to build solid virtual financial advisor-client relations which also benefit the HelloWallet business in the long term as clients are tend to stick to the same “advisor”(in our case a virtual financial advisor – HelloWallet) if she/he understands clients’ needs better.
Question 2: How do the concepts of behavioral finance create challenges for HelloWallet?
HelloWallet’s system creates customized budget plans for the users based on traditional finance and on trend analysis. This poses a challenge to HelloWallet because they do not incorporate the behavioral aspects of their clients. This will lead to creating recommendations that are not suitable to all their clients. Many models have been developed over the years to incorporate behavioral finance traits in the client’s portfolios. There are four different models that attempt to explain the behavior of individuals and their implications on portfolio construction: The Consumption and Savings Model, the Behavioral Asset Pricing Model, the Behavioral Portfolio Theory and finally the Adaptive Markets Hypothesis.
Empirical studies show that some investors exhibit mental accounting where they separate their investments in different accounts in their heads and assign them to different expenses, forgetting to look at them as one portfolio. In this instance this will cause a part of HelloWallet’s target market to refrain from using their software due to this behavioral trait. Clients that have regret aversion and have been suffering from mental accounting will be too scared to adopt HelloWallet’s service out of fear of realizing that they are in financial distress. Those clients do not have a serious desire and readiness to engage in an assessment of their personal financial health; therefore it will limit HelloWallet’s penetration of this market. This intertwines with cognitive dissonance, where people avoid facing financial reality. Statistics show that a vast majority of people suffers from that. People feel discomfort from receiving information that contradicts beliefs that are entrenched in their personalities. Therefore, not wanting to face the idea that “things may not be ok” is a huge barrier for the adoption of HelloWallet by customers.
Naturally humans are prone to resistance to change. They are programmed to stay in their comfort zone and stick to what they are familiar with. Having to take advice from a computer might not be something easily accepted. Moreover, regard to HelloWallet model, clients should incorporate all of their accounts including their assets and liabilities and update them if needed. This process could be a barrier for people suffering for status quo bias. In fact, this bias is an emotional bias in which people tend to do nothing instead of making change. This will affect Hellowallet in two ways. Firstly it will prevent people from registering, as they will prefer sticking with their old traditional way of managing their finance. Secondly, it will reduce the efficiency of the company model, as people will update their data less frequently making inaccurate any outcome from model of HelloWallet.
The way HelloWallet collects clients’ information is via its software online. Users input their answers to HelloWallet’s questionnaire after which they will be categorized and given a budget plan. However individual circumstances change over time, and sometimes change abruptly. As the client moves across his life stages his information should be updated and changed accordingly, but this is not the case. Therefore HelloWallet might suffer from information processing bias known as Anchoring & Adjustment Bias. This will lead to the clients’ results being anchored to assumptions and information that does not hold true anymore.
In fact, the Adaptive Market Hypothesis states that adapting is actually necessary for survival; thus, changes need to be applied to the software occasionally to improve chances of meeting clients’ goals. Anchoring and adjustment bias will make it more difficult for clients to adapt. If the users have a bad experience due to this bias, HelloWallet will start losing business to its competitors. Similarly the lack of personal interaction with customers will result in uncomfortable clients that will not understand the effects of short-term deprivation in relation to the overall long-term savings outcome.
The lack of personal interaction will also destroy value. The company will not be able to build and maintain a consistent approach with its clients, if they are dealing with a computer. If there is no relationship building, the client will move to the competitor or just do his budget by himself after the first negative experience. It might not be sustainable, and might prove hard to retain customer value using this approach.
In addition to that, research showed that people tend to behave impatiently today but plan to act patiently in the future. This is known as self-control bias. The all point of financial planning is to be able to help client to better allocate their financial resources to meet their short-term liabilities and goals while saving for future or long terms needs. The efficiency of HelloWallet advice on personal financial planning depends on how responsive client will be to their advice. In this case, this bias could be an issue, as clients will tend to choose what they prefer (short term satisfaction) instead of what suit best to their financial situation and neglect the long term.