Steering you through cognitive biases
As humans our brains are faced with natural cognitive biases that affect the financial decisions we make. It is important to be aware of them because they impact on how we spend and save money. Part of the coaching we give clients is to listen out for these issues so we can steer them away from these biased decisions when it’s not in their best interest.
There is bias surrounding how we choose between a group of options. When people have a choice between a small or large coffee they will often pick the one that most closely meets their needs. The decoy comes in if a third choice is added, like a medium coffee. Their choice leans towards the more expensive option. This impacts on how we spend our money and our disposable income, which some people see as their savings pot, often depleted due to buying more than they need.
It is human tendency to value something more in the present than in the future. People are more likely to take £100 upfront than £50 a month for 3 months, even though the latter offers someone an extra £50. This has a massive impact on people’s approach to savings, especially for things like retirement in the future.
We tend to put a higher value on things we own, over and above the value of that item if we didn’t own it. This means people tend to pay to retain things even if they wouldn’t necessarily pay to have it if they didn’t own it. This is the main reason why investors stick with certain unprofitable assets, like property for example or something they inherited, the prospect of divesting at the prevailing market value does not meet their perceptions of its value.
Fear of Missing Out
There’s even an acronym for it: FOMO. When faced with the prospect that someone else is getting a better deal, or the use of a service or product made them successful, we feel like we are missing out. This creates in imbalance in our psychological safety. Be aware of social influencers and the impact social media and advertising has on what you buy. Always wait before purchasing something to see if the novelty has warn off and really think about whether you need it before you make that purchase. Don’t forget an influencer may have got that item for free so the return on investment or value will be calculated differently for them as you might calculate it for yourself.
The Less-Is-Better Effect
We tend to place value on goods at the upper end of their value scale. For example most people would value a high quality £45 scarf, over a low quality coat that cost £60. Or an overfilled ice cream serving in a small 200ml cup is valued more highly than an underfilled serving in a 250ml cup. The amount is the same, but we value it disproportionately. We can use these biases to reframe some of our thinking.
We tend to divide money into separate “mental accounts” based on very subjective reasons instead of using sensible, objective sections like amount, risk or interest costs. An example of this could be saving for a holiday in your current account, while carrying some excess debt on a credit card? Even though the interest rate on the credit card is far more than on the current account, our instinct is to ignore that because we are emotionally connected to the idea of going on holiday.