Like most people, you probably like to think of yourself as a rational person. Unfortunately, a lot of the decisions that we make aren’t very rational at all, especially when it comes to money.
The endowment effect
The endowment effect is an emotional bias that causes people to value something they own, sometimes irrationally, a lot higher than its market value. It’s one of many ways that behavioural economists have recognised patterns of thought and behaviour that are detrimental to our personal finances.
Behavioural economics is a blend of economics and psychology, and offers an insight into why we might not be as good with our money as we would like. It’s all very well drawing up a budget, but why is it so hard to stick to it? Becoming aware of our weaknesses can help us to feel a lot richer in the long run.
The anchoring effect
You might think you are able to accurately and objectively assess the price of something presented to you, but in reality you are probably heavily influenced by how much someone else has suggested it is worth.
There’s a famous example of this relating to New York taxis. Before credit card machines were introduced people would tip drivers an average of 8 to 10 per cent. When machines arrived they came with new, suggested tips, 20 per cent, 25 per cent and 30 per cent. As a consequence the average tip more than doubled to 22 per cent. Passengers were “anchoring” what they thought they should pay to the suggestions made by companies wanting them to spend more.
Watch out for this when you are putting an offer in on a house based on how much an estate agent, entitled to a hefty cut of the sale, states is the asking price. Is this price really what you feel the property is worth to you?
Linked to the endowment effect is our hatred of loss, known as loss aversion. We like to hang on to things, which mean we are more upset by losing money than we are happy by gaining it, even if the ultimate financial outcome is exactly the same.
This creates real problems when it comes to us planning and providing for our futures. We are reluctant to give up a greater amount of our salary, for example, even if as a result we get a greater pension top up from our employer and the taxman. Or we are too cautious with our savings, preferring to hold them all in cash because of a fear of losing them. This is often the case even though we are losing money through inflation and may have more of a chance of growing our savings by taking some risks and investing them in stocks and shares or property.
Good news: we’re all irrational – kind of
The good news is that we are all irrational to more or less the same extent. The study of behavioural economics has picked out these patterns of thinking about money that are broadly similar between us all.
There are practical ways to become more confident about your finances, but sometimes the best place to start is by challenging our own behaviour and thinking.