I was at an excellent behavioural finance conference organised by the Michigan University’s Centre on Finance, Law & Policy last week. One of the panels on investor protection debated issues including the impacts of disclosures, choice architecture and social norms marketing on investor behaviour. There was also an interesting discussion on role of advice and advisors in de-biasing investors or exacerbating weaknesses.
In the audience Q & A, in response to a question on the role of financial advice for low-income investors, one of the panelists responded that failures in the market for advice were less of an issue here since by and large, the right answer in most cases is just “save more for the future”. I found myself disagreeing with this notion strongly and one more reminder that the field of household finance has failed to examine the financial lives of low-income families in sufficient detail. In this post, I attempt to share from our KGFS work what are some of the other important aspects where advice seems to matter.
One, given that human capital (NPV of net lifetime earnings) dominates financial capital (wealth) for a low-income household, all of the issues around protecting that human capital is critical because that might make the difference between bankruptcy & resilience in the face of illness/accident/death. Most advice tends to focus on investments and the portfolio allocation question and surprisingly, pays little attention to insurance. Ibbotson et al (2007) provide a comprehensive framework to understand how human capital interacts with investment and insurance decisions. With limited resources, which members of the household should buy insurance? How much insurance should you buy? We find these are important aspects where households benefit from good advice. Specifically, insuring young, adult members of the household for the full value of their human capital is an important step. (One dilemma we faced was that a significant investment in increasing human capital that is made by households is higher education for children. The return to this investment depends greatly on the specific program and employability potential. We did not have the expertise to advise clients on this aspect but it feels like an area closely linked to the role of a financial advisor in this context)
Second, low-income households are typically saving and borrowing simultaneously despite a significant wedge between lending and savings rates (upwards of 20% most times). We don’t understand very well the determinants of this behaviour. Clearly, it is not always the right answer to save. High rates of return on micro-enterprises have been documented by Christopher Woodruff and others. Often it makes sense for households, particularly with surplus labour to borrow to put together the initial capital required to undertake such enterprises. Similarly, households with low but stable cash-flows (the village municipal worker for instance) may find it reasonable to borrow to build a house rather than wait to save up for the same. Working with the household to determine when to borrow and when to save and even combination strategies such as save for the down payment or borrow to save strategies could be very valuable interventions.
Third, the balance sheet of a low-income household has a combination of physical and financial assets. Physical assets such as land and gold dominate. On the liabilities side, there is a combination of formal and informal loans of different maturities. It requires serious skill to arrive at the APR of some informal loans! Which loans to refinance now that advances in financial inclusion are making formal credit more accessible? Which assets may be “dud assets” (ex: a piece of land that is not being cultivated) that could be sold to bring down debt burden? Which loans have a repayment structure that adds to the financial stress of the household? Working with the household to arrive at this comprehensive “balance sheet view” seems like an important role of an advisor.
Of course, there are significant challenges in converting advice into action and requires more careful work and business model experimentation. Equally, careful research and creating the building blocks for good advice for low-income households is also necessary and cannot be extensions of existing advice frameworks. The myth that these households have simple problems that require simple fixes & simple products needs to be challenged by researchers and pioneering providers.