You are waiting in line at the department store when suddenly a banner catches your eye. It states: “3% off on your purchases”. Well, isn’t this your lucky day! You ring up your purchases happy that you ended up saving some money.
Now, you are at the same store the next day. You are standing in the same line, looking for the banner. But what you see is a different banner that says: “3% surcharge waiver”. At this point, you are probably thinking of a number of things. Like, what is this surcharge for? Will you receive inferior quality service if this 3% surcharge is waived? You get your purchases billed, but you aren’t too happy with your experience.
So, what just happened here?
In the first scenario, you were happy that you saved 3%. In the second scenario, you were sad that you saved 3%. Doesn’t make sense, does it?
Well, it really isn’t supposed to. You see, despite being famed for our rationality, human beings aren’t that rational at all. This irrational behaviour where we are sad even when the benefit is the same is known as ‘Loss Aversion’.
Nobel Laureate, Daniel Kahneman in his book Thinking, Fast and Slow, says that loss aversion is the human tendency to care more about losses than wins. So, the pain of losing far outweighs the joy of winning.
You may read this and say, well that’s good to know. But how does it relate to my finances? Well, that’s what we are here for!
Here’s how loss aversion explains some of our perplexing financial behaviours:
Why we hold on to bad investments
If you invest in the stock market or have invested in the stock market, you may be able to relate to this next example.
Let’s say that you bought 5 shares listed on the Singapore Exchange for S$200 each. Your investment seems bullish for the first few months and you can’t wait to sell it for a hefty profit.
However, you soon see the price per share falling. And falling drastically. What do you do?
We bet you are reading this and saying, well, of course, I would sell my shares. And you would. If you were thinking about the situation rationally.
In most cases, you end up holding on to the shares with the hope that the price per share will increase the next day so that even if you don’t make a profit from the sale you can at least break even.
It is this need to avoid a loss at any cost that makes us hold on to bad investments. And not just shares. Think about it. Have you ever held on to a bad purchase (like an out of style but expensive outfit), in the hope that it would once again be in fashion? Or kept with you a broken Walkman hoping that it would one day be considered an antique so that you could sell it for thousands of dollars?
Ideally, you could have returned the outfit and sold the Walkman as scrap. But the presumed losses from these actions far outweigh the gains.
Why we buy insurance policies
If we were to tell you that you could either get S$3,000 for sure or you could participate in a lucky draw with the opportunity to win S$3 million, which one would you pick?
We are sure it would be the guaranteed S$3,000. This is because the stakes are too high to leave it to chance. Sure, S$3 million would be great. But the possibility of being the lucky winner is extremely low. And if you aren’t the winner, then you neither have S$3 million nor do you have S$3,000.
It doesn’t mean that you aren’t willing to take this risk. It’s just that the losses of neither outcome coming to fruition are too high.
Human beings are loss-averse. We are okay with taking risks if it means that we sustain minimal, or ideally, no losses at all.
This is exactly how insurance policies work.
Insurance companies will insure you against losses provided you pay them a premium for the tenure of the policy.
Let’s take home insurance as an example. To protect your home and its contents from any unforeseen circumstance, you buy a standard home insurance policy. You pay S$1,000 as premium every quarter. So, in a year, you pay the insurance company S$4,000. If your policy has a tenure of 5 years, that is S$20,000 that you are spending in terms of premium payments.
If you think about it though, how many of us actually need home insurance? The chances of your house catching fire or water seeping through the walls are next to slim. You could be saving S$20,000 instead!
But you won’t.
Because there could be a possibility of something going wrong. And if it did, you would have to spend huge amounts of money that more often than not, exceed the amount you end up paying as premium. The risk of not insuring your home is too high because the losses that you may sustain are also high.
So, why do we buy lottery tickets then?
Okay. Human beings do not like taking risks. So, why do people willingly buy lottery tickets and participate in lucky draws?
It’s simple. The risk isn’t high at all. A Singapore Sweep ticket will set you back around S$3. You can win anywhere between nothing to S$2.3 million. A loss of S$3 isn’t too much when you think of how much you gain if you win.
It’s this mentality that makes us not just buy lottery tickets but even participate in competitions where we don’t have to invest much in terms of money. It’s also what keeps you going when you are down on your luck.
Ask anyone who has spent hundreds of dollars at a casino. Each dollar is spent with the hope that with the next pull of the lever or the next throw of the dice will change your luck for the better!
Why we use credit cards
Say you are given the opportunity to bid for tickets for a sold-out concert. This is a once in a lifetime opportunity to see your favourite band live. You are also told that you can bid either with cash or with a credit card. But once you choose cash or card, you have to stick to that form of payment for the entire bidding process. You can pull out of the process at any time.
We have no idea how exactly this would play out, but we are pretty sure it would be something like this.
You decide to use your credit card to bid. Why? Well, when you use cash to bid, the physical act of money leaving your hands makes the loss of this amount all the more tangible. As a result, the chances of pulling out of the bidding process sooner (and not getting the tickets) is a very real possibility.
With credit cards, on the other hand, you can bid as much as you want because you aren’t losing money immediately. So, what a credit card tells your mind is that you aren’t actually losing out on anything. Instead, you are gaining something. And that gain is immediate.
This explains why we readily use our credit cards for impulse purchases because you get the product and there is no money that is leaving your wallet at that time.
Of course, you do eventually have to pay your bills and that’s when we’ll feel the loss. For us, this is the end of the line, don’t delay the paying your bills because the high rates of interest are not worth it.
How do you prevent loss aversion from leading to expensive decisions?
Loss aversion isn’t all bad. It is what gets us to buy insurance and we all know that protecting ourselves and our belongings is not just important but it is also cost-effective. Take, for instance, health insurance. Without health insurance, it would be extremely difficult for most of us to access affordable healthcare.
Where loss aversion becomes detrimental is when you use your credit card for all of your purchases without really thinking about how you are going to pay your bill the next month. The fact that you don’t physically lose money when you swipe your card doesn’t take away from the fact that you will eventually have to make a payment.
Same with lucky draws and lottery tickets. Sure, it’s great to take a chance and participate in them once in a while. Where it becomes an expensive decision is when you keep buying lottery tickets in the hope that you will be the lucky winner and the need to win overpowers the slight monetary loss of S$3.
You work hard for the money that you earn. Once you break free from the cycle of loss aversion, you will realise that you probably can save up enough money for a down payment of a home or to fund your education.
You just need to take a step back and think if your mind is playing tricks on you. Do this, and we are sure you won’t come to regret your financial choices.
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