Until recently, dealing with money always carried an aura of gravity and the expectation of uncompromised rationality.
The problem is: that is not how people behave in day-to-day life.
There’s a big difference between the official demeanor people have at a bank manager’s office compared to, say, ordering ice-cream to be delivered at 2 AM on a Tuesday. In real life, customers tend to have a range of habits that banks never intently tried to understand before.
That’s until the challengers arrived. Once the playing field broadened, innovative banking products started seeping through customers’ lives. From micropayments, to cost-sharing, to saving money and financial planning, the game has changed.
As lifestyle products reshape the financial sector, it becomes essential for banks to shed their usual m.o. and try again to help customer form better financial habits . This time, it’s about building an emotional connection with the brand and it requires a more persistent approach than promoting a clever hashtag or creating a dedicated marketing campaign.
To design habit-shaping banking products that marry business growth with customer needs, we turned to behavioural psychology. The reason is simple, although often unacknowledged in the old paradigm: money is a deeply emotional topic.
Research focused on people’s decision-making process around money reveals many blind spots that impact not only personal financial stability, but also influence the entire ecosystem. Once understood they can be used set up guard rails, built from game mechanics, to guide customers to be on track. They also demonstrate that multiple player types exist and therefore that there are multiple tracks.
In this blog, the first of two parts, we look at ten mental biases around money and how they shape interactions with money, banking products/services, and financial institutions in general. In part two, we look at how banks can help their customers to overcome these biases to improve their financial wellbeing.
Us, humans, like patterns and have short memories. It may sound reductionist but it’s true.
Recency bias is proof! This cognitive distortion makes people more inclined to use recent experiences as a baseline for what might happen in the future.
When making financial decisions, recency bias leads people to ignore the importance of saving if, in previous years, their income registered an upward trend. It also reduces the perceived amount of risk of a downturn, which was highly visible in the 2008 crisis.
As a result, people are often unprepared to deal with big changes in their lives that often take a toll on their finances.
One of the most notorious and inconspicuous mental biases is, without a doubt, the confirmation bias.
This human tendency to selectively look for facts that support our feelings and conclusions sneaks into almost every decision we make: the reverse engineering of logic.
When it comes to money, confirmation bias makes people overconfident in their ability to:
- Continue to have at least the same income for the foreseeable future
- Manage debt
- Get back on their feet in the event of a personal crisis that creates financial instability
- Reign in their spending so that it doesn’t destabilize their future financial viability.
The more we want something – such as a new car or a new house – and the more emotionally charged the issue is, the likelier we are to fall for confirmation bias.
The moment we choose to spend money on something, we automatically give up the chance to do something else with it. Humans are so focused on their goals and the need for instant gratification is such a powerful mental habit, that most people never think of opportunity cost.
Behavioral economics researcher and professor Dan Ariely exemplifies opportunity cost in a very practical manner:
“Money is really about opportunity cost. Every time you buy coffee, the money comes from something else. What is this something else? We don’t envision it. With money, the trade offs are really unclear.”
“Every time we buy something, it’s about what we are not going to be able to do in the future.”
“The problem with opportunity cost is that opportunity cost is divided among many, many things.”
Without a constant reminder, without deep analysis, and an effort to be as objective as possible about financial decisions, opportunity cost never shows up on people’s radar, leading to imperfect or even harmful choices.
People don’t deal well with ambiguity, instability, and uncertainty. Our brains have evolved to crave stability, clarity, and predictability to ensure our survival and wellbeing.
So when we’re confronted with a complex or previously unencountered decision – such as buying a house – the ambiguity effect is almost certain to manifest itself. This particular mental bias steers people to choose the option they can better anticipate or have some familiarity with.
For example, that’s why most people choose a steady paycheck as employees instead of starting a business venture of their own and risking their stability, social standing, and lifestyle.
The ambiguity effect also makes people reluctant to adopt new practices, especially when it comes to something as personal and emotional as money. Overcoming ambiguity has less to do with trying to educate people about what’s right or “better” for them and more to do with providing them the experiences that can remove some of the ambiguity, change their beliefs, which then drive behaviour.
Thinking of money in relative terms
“Consumers conceive money in relative terms rather than thinking about each decision individually.”
He showed the impact social norms have on people’s financial habits and decisions and how these choices are made in context.
“People are willing to work for free, and they are willing to work for a reasonable wage; but offer them just a small payment and they will walk away.”
“A few years ago, for instance, the AARP asked some lawyers if they would offer less expensive services to needy retirees, at something like $30 an hour. The lawyers said no. Then the program manager from AARP had a brilliant idea: he asked the lawyers if they would offer free services to needy retirees. Overwhelmingly, the lawyers said yes. What was going on here? How could zero dollars be more attractive than $30? When money was mentioned, the lawyers used market norms and found the offer lacking, relative to their market salary. When no money was mentioned they used social norms and were willing to volunteer their time. Why didn’t they just accept the $30, thinking of themselves as volunteers who received $30? Because once market norms enter our considerations, the social norms depart.”
What’s more, the anchoring effect strengthens this mental bias, nudging people to rely heavily on an initial piece of information (the anchor) when making decisions.
One of the most insidious mental biases is emotional reasoning.
In everyday situations, people decide based on feelings and then use reasoning to build a supporting argument for their choices.
Emotional reasoning influences behaviors such as reckless spending, accumulation of credit card debt, and failure to pay installments. Because of the dual process type of reasoning, people become impervious to logical arguments that their money habits are damaging both in the short and the long run.
This is the human brain on autopilot. In this fairly common situation, cultivating better financial habits helps both bank customers and the companies that provide them with credit and other products and services.
Over-reliance on social proof
One more mental bias that impacts making and managing money is our strong human desire to avoid being wrong, different or excluded.
Neuroscience research on pain that our brains react to threats to our social status – such as being wrong and losing face – as it would to actual pain.
When others disagree with our opinions or decisions, it activates our emotions because we experience what feels like real pain.
“Neuroscientists in Italy have discovered that “social pain” activates the same brain regions as physical pain. […]
As a result, we tend to surround ourselves with people who agree with our choices. The danger with this is that making and managing money often requires contrarian thinking and questioning habits, recognising that if we always do what we’ve always done we’ll always get what we’ve always got. Despite all the talk of failing forward fast, and the massive opportunity failure has to teach us where growth awaits, there remains a lot of stigma around failure, such as is involved with losing money, houses, businesses etc., despite how real or long term the impact of such failure may be.
Long story short, we’d rather squander money than fall from grace socially, and we’d substitute social proof for objective data pretty much any day. This is why people get caught up in social media and buying things beyond their means in order to impress, create or maintain a social perception.
Evolution conditioned us to favor issues that are in front of us right now, on which our survival depended until fairly recently. In the financial world, this bias towards the short term is ever present. Projecting ourselves in the distant future requires intense effort, which most people never make.
This bias highlights how focus on the present, such as the pleasure of a $5 coffee, chips away at a potential saving – giving up 3 coffee cups per week could lead to a monthly saving of $60. But people rarely do this type of math on their own, as their decision-making power is fragmented in the many complex aspects of everyday life. We’re really bad at not saving for or stealing from tomorrow.
The science here is fascinating. When we think about our future selves , the brain reacts in the same way as when it thinks about someone else. Understood in that way, saving for the future is the neurological equivalent of giving money away to someone else entirely.
Quoting from Dan Ariely’s deep understanding of how these mental biases affect financial decisions:
“People are always willing to take money from their future self, but then that puts the future in danger. So we have to work on getting people to think about how much they are really spending and also how they can invest in the future. That will take more of an effort as technology makes spending money easier to do.”
Loss aversion and the need for certainty
Mental shortcuts come in large supplies for human nature, in spite of our perception about ourselves as smart logical folk. What’s more, these mental biases tend to combine and partially overlap, making people even more entrenched in their behaviors and beliefs.
The loss aversion bias and studies around it have shown that people are more emotionally affected by losses than gains, even if the amount lost or gained is identical.
“The psychological impact we feel from losing something is about twice as strong as the positive impact of gaining the same thing.”
Change presents inherent risk, so people stick to the status quo and rarely modify their financial habits. The stronger the need for certainty, the more resistant to change people are, in spite of the financial market being in constant motion.
As people age and become less bullet proof, this loss aversion increases. This has massive ramifications as we enter a world of low or negative interest rates, impacting how the financial services industry thinks about helping retirees build income from their savings. Keeping one’s savings in cash might minimise loss but it might not put food on the table.
Problem-solving based on experience and intuition
The more complex the issue at hand, the more people tend to rely on their experience and intuition to make decisions. Because financial choices are such a unique animal, this approach often leads to irrational decision-making.
Heuristics reveals our cognitive limitations especially when dealing with numbers. Money issues are often seen as pressing by most people, so turning to experience and intuition is one of the fastest ways to solve them. However, this can lead to inaccurate judgments that harm our long-term financial stability.
We want things to have a clear cause and effect, so we can effectively solve a financial need. Trouble is that the financial world is never as simple as we want it to be.
Overcoming these biases
In the second part of this blog we’ll explore how financial institutions can understand these cognitive biases to deliver financial services that benefits both their customers’ growth and wellbeing along with the institution’s sustainable advantage. Stay tuned….