Asking the right question: Reducing financial skill asymmetry between distributors and retail invest
That Indian households invest largely in physical assets is well known. What is not well understood is why this might be so. The reluctance in engaging with formal financial markets in India may have its roots in lack of trust, financial illiteracy, and access to resources that make it easy for households to have all the information while taking financial decisions. There is little doubt that a large fraction of Indian households lack basic financial literacy. This exposes households to rampant mis-selling in financial markets as has been witnessed in India over the last two decades.
Mis-selling, broadly speaking, occurs when buyers predominantly rely on sellers to provide them information that determines their choice, and is exacerbated when such buyers are unsophisticated and do not even know what product attributes to care about, and which questions to ask. Sellers are not interested in working for the customer’s interest — because they are paid by manufacturers and because the rewards for good behaviour remain elusive. Mis-selling adds to the circle of mistrust wherein households just choose to not engage with products and markets they cannot easily fathom.
The policy response has been to elicit appropriate behaviour from the supply side — through caps on commissions, move towards separation of distribution from advice, and better disclosures on financial products. While we improve the policy apparatus to deal with the supply side, is it possible to improve the decision making on the demand side, such that pressure from customers will drive firms “to do right by their customers”, as is the case in non-financial products? What will unleash market forces to get firms to serve the interests of the customer?
One way that the market will work is if customers were discerning of what was on offer to them, and could meaningfully choose the most appropriate product. If customers could demand the better product, then distributors would only benefit if they provided it to them.
In our project, we propose to create an app that will provide customers with a “checklist” of questions that they should ask whenever faced with a distributor of a financial product. The checklist is designed to nudge households with the appropriate set of questions to ask financial agents or distributors. Our hope is that this “nudge” will allow households to assess for themselves whether they deem the product appropriate and suitable by guiding them through the process of decision-making, and in turn, make markets work in the interest of consumers.
What has been done on financial literacy and advice?
The first port of call to improve household financial decision making has been to improve financial literacy. In fact, improving financial literacy of households so that they can make better decisions has long been a goal of public policy. A two-pronged approach to address financial illiteracy has been afoot. It is believed that measures to impart appropriate financial education at every point of the life-cycle — from childhood to retirement — will reduce cognitive and information costs in accessing formal financial markets.
On the other track, there is also a move to create a financial advisory ecosystem that is separate from distribution to prevent incentive misalignments in the expectation that households may not have the appropriate knowledge but know that they can access professionals who have their best interests in mind. This is predicated on the assumption that advice improves and facilitates better financial decisions by individuals. Yet, academic research on both financial literacy and financial advice remains inconclusive. For various reasons, the current approaches do not seem to be working, or at least working as well, as one would have hoped.
Asking the right question
Part of the reason for failure of financial literacy and advice is because households are so far removed from design of financial products that they do not even know where to begin or what to ask. Nor do they trust professional advisors more than they trust friends and family. Additionally, seemingly simple financial products are often complex from the point of view of households. We therefore begin our assessment from this premise that “households do not know what they do not know”.
When households do not know what they do not know, nudging them with the appropriate set of questions to ask financial agents or distributors while they market financial products, may be the first step at a localised intervention. This can help to make households more financially literate without the burden of an additional complex relationship with a financial advisor in the web of financial decision-making. An intervention in this form may have a beneficial effect of reducing the extent of asymmetry in information between distributors and households with minimal cognitive and non-monetary transactions costs, thereby allowing households to gain confidence in such interactions. With the information obtained from this interaction, households may also be able to think and evaluate whether or not the product sold is appropriate and suitable to their needs and objectives. Thus this process allows households to assess the appropriateness of the product for themselves by guiding them through the process of decision-making.
This approach of providing households with a “checklist” app that can guide them in the process of decision making is distinct from earlier approaches to solving the problem of households purchasing ineffective products. This approach has the advantage of providing households with a crutch on what the contours of the relevant information set is, unlike generic financial literacy training, or paternalistic outsourcing of financial decisions to advisors.