Five cognitive biases that affect your Savings & Spending (Part 2)
In our previous article we discussed five cognitive biases:
1.) Attentional Bias,
2.) Serial Position Effect,
3.) Picture Superiority Effect
4.) Authority Bias
5.) Gambler’s Fallacy
Each bias was described with examples and ‘debiasing’ strategies to help the customer mitigate them.
In this second part we will discuss five more cognitive biases, again with an emphasis on debiasing strategies.
1. Isolation Effect (The von Restorff Effect)
A customer’s spending is often steered or manipulated by the Isolation Effect. How is this achieved? Merchants rely on the cognitive bias that when people receive a list of similar things, the most differentiated item will be remembered the most.
Therefore, by deliberately presenting offers that seem pretty similar but then inserting a differentiated one, companies can nudge you to where they want.
If this seems intuitive, that is because it is one of the oldest findings in psychology as far back as 1933 at the University of Berlin.
Look at this list: jrm, tws, als, huk, bnm, 153, fdy.
Which one stands out?
That is what Hedwig von Restorff asked participants nearly 90 years ago!
Merchants use creative ways to ensure consumers make the choices most advantageous to the merchant.
The next time you want to spend your hard-earned money on an item, try playing a game.
Ask yourself which product or service you are thinking of and what differentiates it from the others. Remember, merchants know that people tend to disregard elements common to both options to simplify and focus on what differs. There is a high likelihood that the merchant will highlight the differences and justify why you should spend more.
That is the Isolation Effect at play.
A good debiasing technique will be to judge things on their common traits and not their differentiated attributes; then make buying decisions based on your preferences.
2. Hyperbolic discounting
When customers face two similar rewards or values that arrive one after the other, they tend to prefer the reward or value that comes sooner.
The discounting of the second reward or value is often in line with how long it takes to arrive.
In simpler terms, people desire an immediate reward rather than a higher-value, delayed reward.
But this desire does not follow a normal curve but a hyperbola.
Once a certain amount of time passes, the desire for an immediate reward fades, and we are happy to wait for the delayed higher-value reward.
How much time must pass before we think this way?
That depends on what it is we are talking about, and our will power. What is certain is that experiments have shown that we all seem to apply this kind of discounting over time, some of us more than others.
Let us take something we have all seen while shopping online; payment plans that don’t make any financial sense.
For example, a website offers you a payment plan of 1 month for £9.99 or 1 year for £39.99.
Of course, if you work it out, the one year plan is £3.33 per month, so why would anybody in their right mind pay £9.99, three times as much?
The answer is hyperbolic discounting.
Merchants are banking on the fact that consumers want to spend less now, even if it means more in the long term.
The best debiasing technique is delayed gratification, made famous by the Marshmellow Tests at Standford University.
Simply put, exercise will power and wait for the higher-value delayed reward.
3. Risk compensation or Peltzman effect
Ever heard the saying, ‘brakes help a car go faster’? Well, that seems counter-intuitive but is it?
If you know that you can slow down quickly and reliably, thanks to state-of-the-art braking technology, you will feel more comfortable putting your foot on the accelerator.
Strangely, good brakes can make a car less safe because we are willing to take bigger risks.
Similarly, customers will change their behaviour in line with the perceived external level of risk and not necessarily their internalised risk levels or appetite.
This is known as risk compensation or the Peltzman effect.
So when it comes to investing our savings, the current legal and regulatory environment has made investments safer.
Consequently, we have become overconfident and now take more risks than we otherwise would in a less protected regulatory environment.
If you doubt this, how easily do you hand over your credit card for purchases online, knowing that you are protected by section 75 of the Consumer Credit Act?
If that protection wasn’t there, would you still buy the product under the same circumstances?
If you wouldn’t, then you are most likely risk compensating or succumbing to the Peltzman effect.
The chances are that, without the section 75 protection, consumers would make fewer purchases.
In a twisted way, what is making purchases safer is making us spend more.
Your debit card does not come with a section 75 protection; have you ever looked at the types of purchases you make with that card and compared it to your credit card?
You might be in for a revelation.
4. Commitment bias
Have you ever noticed how you seem reluctant to get out of something you know is a bad idea after you have made a commitment?
I’m sure that feeling is familiar but don’t be embarrassed about it.
Of course, it is even more painful when it involves a lot of money.
Have you also noticed how many products or purchases seem to have some elaborate commitment devices to keep you interested?
Well, that could most likely be orchestrated to make you succumb to Commitment Bias.
This is based on the notion that people prefer to hold onto past ideas and decisions even when new evidence or events makes doing so irrational.
This is similar to Semmelweis Reflex (effect), where people tend to reject new knowledge and evidence when it contradicts their own existing or established norms, beliefs or concepts.
Also, commitment devices are shaped by Reciprocity Decay; people’s desire to want to commit wanes as time increases.
If you find commitment ‘calls’ coming in thick and fast, slow down; it’s the only antidote to commitment bias.
Log off, stand up and go away and think.
You are the buyer; time is your friend and more often on your side than on the seller’s side.
5. Bandwagon Effect
When it comes to spending, we almost always get a second opinion; it’s human nature.
Reviews and recommendations are second nature in today’s commercial environment.
But what if that environment was being manipulated to make you spend?
Merchants nudge users to spend under the notion of social attraction, which works on Herd Mentality and the Bandwagon Effect.
Describing what most people do in a particular situation encourages others to do the same.
Social buy-in is a powerful tool, but no two finances or budgets are the same; your money’s push and pull factors are unique to you.
And that is primarily because your desires, coupled with your constraints, produce a unique permutation.
Only you know if that purchase is suitable for your finances regardless of the reviews or recommendations.
To avoid the Bandwagon Effect, first, ascertain if an investment fits into your budget.
Then look at only the negative reviews and recommendations.
If you still wish to go ahead with the purchase, then you have overcome all social attraction and distraction.
About the Author
Dr. Jim Coke is a member of the Chartered Banker Institute and the Chief Behavioural Officer at Level Financial Technology Limited.
The views and opinions expressed in this article are those of the author. They do not necessarily reflect the official policy or position of any other agency, organisation, employer or company. Assumptions made in the analysis are not reflective of the position of any entity other than the author.
