Income volatility and its consequences for MSEs

Financial volatility, in income and expenses, creates a constant state of financial uncertainty that distorts decision-making, heightens stress and undermines the financial stability and growth of micro and small businesses (MSEs) in Colombia and beyond. These pressures can be meaningfully reduced through focused interventions.

1. Simplify as much as possible ― Reduce the amount of steps and information users need to complete a process, automatically input information into forms and pre-select answer choices where possible.
2. Prioritize flexibility across product/service design and offerings ― Allow users to choose conditions of their financial product (e.g. repayment date, frequency or amount) and offer payment skips that a user can trigger unilaterally throughout the financial term.
3. Create opportunities for people to see the fruits of their efforts and receive repeated reminders ― Offer tracking tools, such as calendars or progress bars, that highlight current successes and continuous to-dos. Encourage people to write down a highly specific pre-commitment to a financial behavior before the necessary moment of action.

Mastercard Strive Colombia, an initiative from the Mastercard Center for Inclusive Growth, seeks to mitigate the effects of income volatility on MSEs in Colombia and Latin America. Through economic research, observation and insights (ANIF), promotion of digitalization (Fundación Capital) and innovative design and application of behavioral economics (Common Cents Lab (CCL)), the team works to ensure MSEs have the information, tools and techniques to strengthen their resilience, overcome volatility, achieve stability and, where desired, growth.

Income volatility can have a deep and damaging effect on people and businesses across income levels. These sharp and unpredictable fluctuations in revenue and expenses especially impact micro and small businesses (MSEs), who often function on thin operating margins. The phenomenon threatens and undermines business’ financial resilience, impacting both stability and growth.

In economies with significant reliance on micro or small entrepreneurship, the economic, physical and mental strain of income volatility extends to a significant portion of the population. In Colombia, 98% of registered companies are MSEs (Superintendencia Financiera de Colombia & Banca de las Oportunidades, 2023). They employ 72% of the Colombian workforce and account for about 40% of GDP, contributing significantly to economic growth (BBVA Research, 2024; Wheat & Farrell, 2017). With such material consequences, efforts to mitigate the negative effects of income volatility are key to strengthening MSEs’ financial resilience and are deserving of resources and priority. To this end, behavioral science is uniquely positioned to understand and overcome the underlying psychological – and cyclical – complexities of income volatility.

The 2023 Small Firm Diaries (SFD) study in Colombia underscores why smaller firms are so often devastated by income volatility. Dramatic 52% fluctuations in revenue, 57% in expenses and 100% in operating month-to-month result in cash-flow swings that force consequential financial trade-offs and impact employment stability. Only ~1 in 5 observed workers in the SFD study received pay for at least eight months of the year, highlighting significant payroll discontinuity and weaker job quality. A simultaneous and historic preference of cash reliance and discomfort with government visibility begins to explain MSE’s lesser participation in formal financing (Eplee et al., 2023). While leaning into the status quo may feel safer in the short run, it undercuts creditworthiness, pushing entrepreneurs toward informal lenders that are more costly and risky.

The behavioral consequences of income volatility

When income is unpredictable, financial decisions are made in environments defined by urgency, uncertainty and stress. The behavioral lens helps to uncover why income volatility so often leads to suboptimal financial choices, even among highly capable and motivated entrepreneurs.

Generally, people exhibit a clear and persistent preference for short-term rewards, even with the knowledge that benefits in the long-term would be greater. Known as present bias (O’Donoghue & Rabin, 1999), this phenomenon is exacerbated by income volatility. When people are confronted with unpredictable income, they consistently prioritize spending in pursuit of smaller, immediate rewards over financial considerations of larger rewards in the longer term. This manifests – among other things – in reduced savings and a lack of (or reduction in) business investment that can have severe impacts on business’ long-term wellbeing. Evidence indicates this obstacle to saving remains consistent across income levels (West et al., 2020).

The overwhelming pressures fueled by income volatility also limit entrepreneurs’ mental bandwidth, negatively affect physical wellbeing and have been found to induce a scarcity mindset. As income is (or is perceived to be) a scarce resource, financial stresses force mental efforts to focus on addressing that need, reducing capacity to make decisions in other domains (Mani et al., 2013; Mullainathan & Shafir, 2013). The narrowed attention on meeting immediate needs can lead to ignoring considerations of future consequences. Scarcity mindset has, for example, been found to lead to overborrowing (Shah et al., 2012), more risk-taking (Liang et al., 2021) and goes so far as to manifest in physical consequences. It is linked to insomnia and poor sleep quality (Sayre, 2022), both of which are associated with declining mental and physical health.

The path forward (behavioral opportunities)

Considering the compounding mental, physical, financial and external consequences of income volatility, the role of financial service providers (FSPs) in designing and evaluating their offerings with income volatility consequence mitigation in mind is more important than ever.

1. Make it easy for users: reduce friction wherever possible

Complexity, difficulty, effort and time investments are some of the primary obstacles that disincentivize behavior (Hreha, 2023). Reducing the pain of completing a task is incredibly effective in motivating behavior.

A. Reduce time, steps and requirements across processes and procedures.

This could include requiring less information on a form, one less document to upload or one less in-person appointment. The more is asked of a user, in steps or effort, the more opportunity there is to abandon a task. In the credit process, for example, the significant time investments and attention required with no guarantee of approval (López & Malagón, 2024) alongside high financial costs and perceptions that excessive documentation would be required (ANIF, 2024), discourage businesses from seeking formal financing.

B. Provide decision aids, such as pre-selected defaults, along processes to reduce required effort in decision-making.

A default maintains all possible options for users while pre-selecting one. This identifies a priority between options through an implicit endorsement while maintaining complete agency (Jachimowicz et al., 2019). Defaults reduce the mental effort required to make financial choices, help reduce choice paralysis and extend users’ capacity to enter and complete processes. In a study conducted with a Fintech, we found that setting a default that indicated to users the recommended course of action increased the creation of emergency savings funds from ~17% to ~43%.

C. Automate all possible steps in a process and encourage users to choose automation for repeated actions.

Solutions that automate complex behaviors and decisions have the largest impact on behavior change (Beshears & Kosowsky, 2020). We found that encouraging users to turn on automatic loan repayment settings made fewer late payments and paid off more of the credit faster.

2. Offer flexibility in financial products and services

Businesses with volatile incomes, especially MSEs with smaller margins, function with uncertainty about their financial future – in both the short and long terms. Offering flexibility built into products and services allows MSEs to adjust to their ever-changing financial situation and can mitigate the effects of this uncertainty.

A. Offer flexibility that allows users to tailor a product to their unique cycle or circumstances (e.g. flexibility in repayment amounts, repayment due dates or repayment frequency).

High income volatility makes it difficult to commit to fixed repayment amounts (López & Malagón, 2024). As little as a 7-day gap between paying expenses and receiving income has been found to decrease the likelihood of a business fulfilling its financial commitments (Dahan & Nisan, 2020). Beyond improving repayment among current users, flexibility can also make the product attractive and accessible to MSEs that do not yet participating in the market. Differing levels of flexibility can attract and cater to difference audiences.

1. Flexibility in choosing credit/loan terms ― Flexibility at the onset that becomes rigid once the term begins can still be impactful for businesses. Allowing small business owners to choose their payment dates, has been shown to increase users’ perceived likelihood of making payments on time.
2. Provide flexibility throughout the term of the financial relationship ― Allowing flexibility that can be used throughout the credit term can serve as an insurance for users’ unpredictable income fluctuations. Researchers have found that offering repayment skips, pauses or reserves to be triggered when a borrower needs can improve repayment rates, lower the probability of defaulting and improve business outcomes (Barboni & Agarwal, 2023; Battaglia et al., 2024).

3. Provide automatic tracking indicators and encourage pre-commitment to financial habits.

People place greater focus and importance on information that is salient – stands out, readily available and repeated. As such, reminders and reinforcement across healthy financial decision-making processes – including acknowledgement of effort, highlighting progress and encouraging pre-commitment – can keep goals top of mind and help users overcome short-sightedness at the moment of action.

A. Introduce tracking tools such as calendars or progress bars.

Tracking progress, success or the benefits of financial actions can be highly motivational, as evidence indicates that proximity to a goal increases both the effort put into reaching that goal, and the likelihood of completion (Kivetz et al., 2006). Research consistently indicates that increasing the frequency of progress monitoring improves rates of goal achievement (Harkin et al., 2015). For instance, goal tracking calendars have been found to improve savings among small businesses, as they are motivated by seeing the benefits of their efforts (Grohmann et al., 2020).

B. Encouraging users to very specifically pre-commit to a financial behavior (e.g. payment amount or date).

People are more likely to carry out a behavior when they have very specifically committed to that behavior ahead of the moment of action, as pre-decision helps avoid short-sightedness. Pre-commitment to saving ahead of coming into money can improve savings rates. A study we conducted requesting pre-commitment ahead of tax refund receipt nearly doubled savings rates (from 12% to 22%) and choosing a savings contribution ahead of a pay raise has been shown to significantly increase amounts saved over multiple years (Thaler & Benartzi, 2004).

Income volatility among MSEs reflects a fundamental duality: though shaped by structural realities – informality, markets, minimal margins, etc. ― it is also connected with behavioral tendencies that influence how entrepreneurs perceive risk, financially plan and respond to financial fluctuations and shocks. Unpredictable income leaves MSEs struggling ― or afraid ― to make forward-thinking financial decisions. This (1) constrains stability, resilience and growth and (2) weakens both the businesses, households and local economies that rely on them. There is clear opportunity here for stakeholders ― financial service providers, policymakers and others ― to design and reimagine products, services, regulations and ecosystems that reflect real income patterns and human financial behavior. Ultimately, mitigating the effects income volatility for MSEs improves more than just financial health. It carries broader implications for psychological and physical wellbeing, social cohesion, economic stability and overall quality of life - strengthening not only businesses and financial systems, but also the communities they serve.

For a deeper dive and the list of references, please check out our full report available in English and in Spanish.

Our free and quick Finsights Guide is also available to guide you in applying behavioral strategies to your financial product today!

If you are interested in learning more about Strive Colombia, please visit our website at https://www.mastercardstrive.org/regions/colombia, or we invite you to listen to our Financial Inclusion Week conversation with ANIF, The Ups and Downs of Income Volatility: Behavioral Impacts and Opportunities for MSEs.