So, you're a regular reader of the business pages and you reckon you're
smarter than the average bear when it comes to financial matters. Well,
here are some common "biases" to which people fall victim when making
decisions about financial products. See if you can put hand on heart and
swear you've never made any of these mistakes. If you can, you're a lot
smarter than me.
Have you ever overspent on your credit card, or
paid off less of it than you know you should? And if you pass that one,
try this one: are you confident you're saving enough to ensure your
retirement is as comfortable as you'd like it to be?
If you fall
short on any of those, you've been affect by what psychologists call
"present bias" and behavioural economists call "time-inconsistent
preferences" (so in the competition to make your discipline sound
smarter than it is, the economists win).
People often succumb to
the urge for immediate gratification, thinking too little about the
problems this will create for them down the track. It's natural -
economists would say "rational" - to value the present more highly than
the future. But if you go too far in that direction and end up
regretting the choices you made, you've overvalued the present and
undervalued the future, making your preferences inconsistent over time.
Most
of us have a self-control problem in some field or other. People who
are overconfident about their ability to control themselves in the
future - to, say, manage heavy repayments - will make their lives more
of a pain than they need to be.
Those who are more realistic often
use "commitment devices" to impose self-control on themselves. The most
extreme example is to cut up your credit card. Compulsory
superannuation contributions for employees are a kind of
government-imposed commitment device to help us save for retirement -
which may be why so few people object.
Businesses exploit our
self-control problems by, say, designing a gym subscription that seems
cheap, but only if we keep using it for the length of the contract. Or
by starting a credit card or home loan with a low interest rate (known
in the trade as a "teaser" rate) but then jumping to an overly high
rate.
Have you ever delayed moving to a better bank account, or
putting some of your savings in a term deposit paying a higher interest
rate? The experts call this "procrastination" (now that's a surprise)
and class it as a version of present bias.
Examples are legion:
deciding to cancel something but not getting around to it, not checking
to see if the accounts and the loans and phone contracts you have are
still the best available, or not putting much work into searching for
the best deal in the first place.
This, too, leaves you open to
exploitation by businesses. Some offer a "free trial" while knowing few
people will cancel the deal when the paying period begins. Even
requiring cancellation by post exploits our inertia.
Have you ever
driven a hard bargain to buy a new car, but then gone overboard buying
extras like rust-proofing, window-tinting or an improved security
system? Have you ever bought a new TV or computer, then been sold
extended warranty insurance?
Have you ever hung on to shares now
worth less than you paid for them, hoping they will come good and you
won't have to accept you made a bad decision to buy them?
If so, you've fallen victim to the biases of "reference dependence" in the first case and "loss aversion" in the second.
It's
virtually impossible to look at something and decide what you think
about it without consciously or unconsciously comparing it with
something else. When buying a car, we compare and contrast all the ones
we could buy. Failing that, we compare the one we're thinking of buying
with our old one. If we don't have an old car to compare with, we
compare having one with going by bus.
Comparisons are almost
unavoidable. But we're so dependent on having something else to compare
with - use as a point of reference - that if a sensible comparison isn't
available we'll use one that makes no sense at all.
An old
experiment asks people to estimate how many African countries are
members of the United Nations. Most people have no idea. But if, before
or while asking the question I mention 60, many people will seize on
that number. Do I reckon the number of countries is more or less than
60? How much more, or how much less? That's an easier question to
answer.
This way of making decisions is known as "anchor and
adjust" and all of us use it all the time, consciously and
unconsciously. Trouble is, 60 was a number plucked from the air.
Experiments show that if you mention 100 rather than 60 before asking
the question you get higher answers.
Point is that our reference
dependence makes us easy meat for clever salespeople. We go overboard
buying extras for our new car because they all seem so cheap relative to
the huge sum we've just forked out to buy the car.
Likewise with
extended warranties, which are notoriously overpriced for what little
you get back. Anyone wanting to buy "peace of mind" is usually
overcharged.
It's an empirical fact that most of us hate making losses much more than we love making gains. By about two to one, they say.
This
explains why we do silly things like hanging on to dud shares we should
sell - and then should put the proceeds into something with better
prospects of gain.
These examples come from a report on
behavioural economics prepared by Britain's new Financial Conduct
Authority, which has been charged with finding ways to prevent
businesses taking advantage of our lack of rational thinking. Good idea.
