Should you find yourself putting off renewing your home insurance until tomorrow, or feeling confused by compound interest, you can blame evolution.
Experts say that we humans are not designed to deal with complex financial conundrums, and that’s why so many of us are prone to making mistakes.
Take this puzzle, for example: Imagine you borrow £100. Over the next 12 months you repay the loan by paying £10 a month — a total of £120 over the year. What rate of interest did you pay on your loan?
According to Daniel Read, professor of behaviour science at Warwick University, most people think the answer is 20 per cent.
Experts say that we humans are not designed to deal with complex financial conundrums, and that’s why so many of us are prone to making mistakes
But most people are wrong.
Because the amount you owe is falling each month but your repayment is constant, the actual interest rate you end up paying is closer to 40 per cent. This is just one example of how our brains are not wired to make the best possible financial decisions.
Dr Sotiris Georganas, reader in behavioural economics at University College London, says: ‘We are making decisions all day every day and 99 per cent of them aren’t crazy.
‘But there are some systematic errors we make because of our nature and the environment we evolved in.
‘We didn’t evolve with laptops and spreadsheets, but our decisions make sense for, say, the jungle where we did evolve.’
Humans are prone to mistakes because, in many instances, our instincts when it comes to finances are wrong, and companies are well- versed in how to take advantage of them. So what are the common tricks that our brains play that leave us poorer?
Here’s what you need to know . . .
USE YOUR WILLPOWER TO SAVE A FORTUNE
In one of the most famous psychological experiments of all time, children were given a marshmallow and left alone in a room.
They were told that if they did not eat the marshmallow then after 15 minutes they would be given another, and could then eat them both. Only a third of those who tried to resist were able to last the full 15 minutes.
Perks: If you saved £2.50 a day on coffee you could have more than £900 after a year
It sounds silly, but it shows just what easy prey humans are to temptation. Immediate gratification is far more attractive than having to wait. You can see that when you queue for your morning coffee.
It’s a common money-saving tip used by experts: if you saved £2.50 a day on your latte you could have more than £900 after a year. But the problem is, you want your coffee now.
Mr Read says: ‘Most people would rather have the immediate benefits that come from their piping hot, comforting caffeine fix than think about the annual boon that would come as a result of not indulging.’
Experts say that could be because the benefits of saving £2.50 a day are so vague.
If, as you went to pay for your cappuccino, the barista pointed out that if you ditched coffee for a year you could have an extra £6,336 at retirement, you might think a little differently.
That’s what would happen if you saved £900 and put it into a pension which grew at 5 per cent a year for the next 40 years.
Having a concrete alternative makes us far more likely to make a good decision.
If you can’t do without a caffeine fix, think ahead before leaving the house and take a flask. Or could you wait until you arrive at the office or return from shopping?
The same goes for other little expenses through the day, such as a pricey sandwich, bottle of water or a taxi fare when you could walk.
BE SURE TO CLEAR THE RIGHT DEBTS
Here’s another puzzle: if you have debt on two credit cards, one with a rate of 25 per cent and the other 15 per cent, how would you manage your repayments?
Financial products are notoriously difficult to compare and while the headline interest rate may say one thing the actual rate you pay is likely to be far more than you imagined (remember that first puzzle?).
If you have two cards with different balances and different interest rates then the easiest choice is generally just to pay an equal amount off of each.
But according to studies, the best way to minimise the amount of interest you pay is to meet the minimum repayment on both, then direct any extra money towards the card with the higher interest rate.
James Daley, founder of Fairer Finance, explains: ‘If you have two cards you need to make the minimum repayments on both to avoid extra fees — which are often around £12 each time you fail to do this — and to avoid your credit rating being hammered. Then you need to decide which card to divert more of your income towards.’
If you have two cards with different balances and different interest rates then the easiest choice is generally just to pay an equal amount off of each. But there’s a better way
Say you had £5,000-worth of debt on your 15 per cent card and £5,000 on the 25 per cent card.
If you paid off £100 on each card every month, you’d end up paying a total of £12,558 in interest — and it could take more than 32 years to clear the debt.
But if you paid just the minimum balance on the card charging interest of 15 per cent, and put a larger £150 a month sum towards the card costing 25 per cent, you would end up paying £8,083 in total interest — £4,475 less.
It should also take you nearer 28 years to clear the debts at those rates, according MoneySavingExpert’s calculator.
Yet rather than hone in on the details of APRs and minimum repayments, humans are prone to paying equal amounts, or focusing on the size of the balance on each card.
Mr Read says: ‘Part of the problem is that we are time poor, and figuring out the subtle details of the difference between loans rates is maybe not considered a great use of our time.’
It’s why so many of us pick the cheapest insurance option on a comparison site rather than considering whether it’s actually the best value for money.
Another study of people with multiple credit cards found those who focused on one card at a time in this way paid off more of their debt than those who made equal repayments on several cards.
This might seem counterintuitive, but focusing on the card with the smallest balance first had the best effect when it came to encouraging people to pay off their debt, because there was a sense of achievement when the balance was cleared. That spurred them on to pay off the rest.
Mr Read says: ‘A big challenge for people is that it’s hard to directly compare financial products.
‘The regulator is working on this to ensure companies present information to us in a way which is comparable, but even then, it is hard for us; concepts such as compound interest are difficult.’
THINK OF WRINKLES TO BOOST PENSION
If you’re asked to imagine the future, you might think of flying cars and robots, but it’s difficult to consider what you might look like or what your needs will be.
Short-termism is a common human trait which means rather than planning for the future, we tend to avoid thinking about it.
Part of the problem here is also a tendency to procrastinate — it’s the reason you put off shopping around for insurance and why you say you’ll set up that savings account tomorrow rather than today.
Dr Georganas says: ‘It’s your present self who doesn’t want to do something, wrestling with your future self who will wish they had.’
One of the starkest examples of this is how much we are under-saving for the future; research by Scottish Widows found a huge nine million people are saving absolutely nothing for their retirement.
Yet one study showed that people made better savings decisions when shown an aged picture of themselves. Mr Read says: ‘It helped them to imagine and identify with their future self.’
One study showed that people made better savings decisions when shown an aged picture of themselves
In instances such as this, legislation can be put into effect to help us avoid our short-termist tendencies.
The launch of auto-enrolment into workplace pensions, for example, has got more people saving for the future than ever before, simply by making it a small effort for people to opt-out.
DON’T PANIC WHEN OTHERS DO
Most people know that when investing they should ‘buy low and sell high’. It means buying shares in companies when they are cheap and undervalued by other investors — and then selling them when they are popular and the price has climbed, to pocket a profit.
But all too often we don’t follow this seemingly easy advice, and instead we wait for others to act first before following.
Herd mentality — that is, following the crowd — makes us feel safe and makes our choices feel validated. But it can lead to other problems. If we keep buying those shares when everyone else is, we are likely overpaying for them rather than walking away with a profit. And, if the price plunges, we may refuse to sell.
Dr Georganas says: ‘Losses loom larger than gains. To most people, losing £1 is a much bigger deal than gaining £1 and this has a huge effect on our behaviour.’
If people make a loss on an investment their instinct is to hold on for the price to recover so they can recoup it.
After all, it’s only when you admit defeat that you’ve really lost any money.
But Dr Georganas says: ‘What you should really do is ask yourself what you think the price will be in six months’ time. If you don’t believe it will rise, then you need to sell.’
INVEST CASH IN HUMAN INSTINCT
For those who can learn to fight their poor financial instincts, there are gains to be made.
Jeremy Lang, co-founder of investment firm Ardevora, uses cognitive psychology to help pick his investments, aiming to take advantage of other people’s errors and biases.
He says: ‘As an example, cognitive psychology tells us that company managers, despite being intelligent and well-informed, are susceptible to being over-confident.’
That confidence might draw investors in — but it can often mean that the management takes too much risk, gets something wrong and then the share price goes tumbling.
For that reason, he doesn’t like large High Street chains such as Next and M&S, which he says are ‘in denial’ about shoppers’ changing habits, and instead prefers those which are embracing change such as online retailers Asos and Boohoo.
Unlike many fund managers, who meet with hundreds of company bosses a year, Mr Lang prefers ‘to keep a safe distance’ and look at factors such as how much money the firm is making and how the industry it operates in is doing.
His approach has seen his UK Equity fund return 97 per cent over the past five years compared with an average of just 64 per cent among similar funds.
And when he does find a company he thinks is worth investing in, he hopes other investors haven’t yet spotted the opportunity so he can be the one to exploit it.
‘Financial analysts can often under-appreciate how fast and for how long unusual businesses can grow. Meanwhile, investors can often become nervous about a company after a traumatic event,’ says Lang.
So just remember — humans are prone to the odd mistake, but good financial habits are possible if you spot them early enough. And when things get too tricky, you can always use a calculator.
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