Psychology of Money at Action Design Meetup

On the evening of July 15 I gave a talk on psychology of money. It was a brief summary of the Thinking Money (2 days) training I give.

We talked about relativity, loss aversion and mental accounting and why they make sense from an evolutionary psychology point of view. We also talked about how these effects manifest themselves in real-life and how they could be used to design better services.

Here are some pics I got via twitter from some participants:

Here's a tweet from Tina Safaie:

Loved "The Psychology of Money" with @NicholasNaumof @ActionDesignDC! I'll never think the same way about my money...

For me it was a pleasure and Thank you to everyone who showed up. 

Special thanks to Kate and Zarak who organized this very nice event!

Looking forwards to the next Action Design Meetups.

Why our Judgment Shortcomings about Money Aren’t Irrational

The field of Behavioral Economics / science pointed out how much of human judgment and decision making does not conform to models of economic rationality.

Oversimplifying, we could say that behavioral science gathered mountains of evidence on our own irrational thinking and behavior.

Many introductory materials such as lectures or presentations use a very popular illustration:

We like to think that we are like Mr. Spok, but in reality we are more like Homer Simpson.

This is a very catchy illustration, but it is utterly wrong because in order to understand human judgment and decision making we shouldn’t use fictional characters as references.

In order to deeply understand how Homo Sapiens thinks, we need to look back to our very distant evolutionary ancestors (early Homo Sapiens and pre-Homo Sapiens species).

Simply put, in order to understand how modern humans think, we need to look back at cave-people.

Loss aversion is probably the best known psychological effect (some would call it a judgment bias) when it comes to thinking and decision-making about money.

From a normative economics point of view, the fact that we hate losses roughly twice as much as we enjoy equivalent gains makes no sense – is irrational. We should be willing to put in the same amount of effort for both avoiding a loss of 100 dollars (euros) and gaining 100 dollars (euros). Yet, we know that things do not happen like this… people put in more effort to avoid a loss than they do to achieve an equivalent gain (i.e. 100 dollars).

However, this phenomenon – this way of thinking – made perfect sense for our evolutionary ancestors. In other words, it was (is) evolutionary rational to hate losing what you have more than you enjoy gaining some more.

By evolutionary rational I mean anything that enhances an individual’s chances of survival till reproductive maturity, achieving reproductive success (having offspring) and investing in heirs till they reach reproductive age.

To oversimplify, anything that allows an organism (person) to become a grand-parent can be seen as evolutionary rational.

Just as a note: evolution favors “metabolically cheap” solutions. Anything that brings a cost without providing an advantage in sending one’s genes into future generation(s) will be eliminated in the evolutionary process.

Let’s return to why loss aversion was, in fact, very (evolutionary) rational for our very distant ancestors.

These individuals lived in resource scarce environments. This is not to say that they were starving on a permanent basis, rather it is to say that the available (and accessible) resources were matching the minimal needs of our very distant ancestors.

In such an environment, it is more important to not lose the resources one has than to acquire additional resources. This is from an evolutionary point of view.

Putting things differently, holding on to the few resources one had offered evolutionary benefits (sending one’s genes into future generations) that were higher than the evolutionary benefits of acquiring additional (new) resources.

I am aware that I have simplified things quite a bit, but I guess you get the main idea.

What some call judgment biases such as loss aversion, mental accounting, relativity (contrast effect) etc. might very well be part of what made our generations’ existence possible.

Next week I will present (live) the three major psychological effects on thinking about money and their evolutionary explanations. Most importantly we will explore how Loss aversion, Mental accounting and Relativity influence our decision making about money in real-life situations.

Moreover, I will present some illustrations on how these so called judgment biases can be harnessed for designing better services that improve people’s lives.

The talk we be on July 15^th in Washington DC and it is part of the Action Design Meetup events. 

If you are in the area, join themeetup. 

What is a Bargain?

A while back, I heard the following definition for a bargain:

It is something that you don’t need at a price that you can’t resist.

Although this definition might seem too anecdotic and a bit “unserious”, it is a wonderful illustration of the psychology behind bargains and it explains why sometimes we buy not-so-useful things.

The definition above illustrates that there are two types of utilities involved.

For those of you who don’t know what utility is, it is a fancy word used by economists to describe benefit or pleasure or happiness. For example consuming a bottle of water will bring some benefit / pleasure / happiness to the drinker.

Normative economics takes into account the utility derived from consumption of the good or service. Behavioural economics, however, acknowledges that alongside the benefit of consumption, there is some pleasure (utility) that comes from the purchase itself. This was named by Richard Thaler (1985) as Transaction utility.

In other words, Transaction utility is the pleasure one gets from the deal itself.

Quite interestingly, in the case of a bargain, the consumption utility is close to zero or even negative (i.e. you have to do something with that useless thing and most likely it will bring some head-aches.) while, at the same time, the transaction utility is very high – a price that you can’t resist.

What I believe happens in the moment of purchase is that (at least some) people recognize the low consumption utility, yet can’t resist the great deal. Subsequently, because of confirmation bias, they try to find arguments that support the purchase. More specifically these arguments are directed towards tackling the low consumption utility. In other words, although they realize that the item itself is not particularly useful, they conjure possible uses for the item.  

On July 15 I will Speak About Psychology of Money at the Action Design Meetup in Washington DC.

Join here

It’s a great deal :)

Thaler, R.H., (1985), "Mental Accounting and Consumer Choice," Marketing Science, 4 (3), 199-214.  

Can Banking Services Go from Utilitarian to (Truly) Useful?

Banking (consumer) services are, well, utilitarian.

For quite some time now, (some) banks tried to become more user-friendly, more humane and to focus a bit more on the people side of their business and less on the technicalities of numbers.

Despite, or maybe because of, these efforts, many bank customers have a difficult time understanding how (some) banking products and services actually work.

Moreover, some bank customers exhibit what seems like irrational behaviour such as having at the same time both savings and loans.

One might believe that such behaviours are caused by lack of knowledge, but, most often, this is not the case. Moreover, financial literacy has been proven to have a similar effect as holly water. It does not do any harm, but neither does it do any good.

Even financially literate people still show the same biases as naïve consumers.

The reality is that many (apparently) irrational behaviours related to money, including having simultaneously both savings and loans and paying very high interest rates for buying seemingly useless fancy products, are driven, in fact, by a form of profound rationality – evolutionary rationality.

Most learning programs, articles and books on behavioural science focus on presenting, (sometimes) explaining and giving insights on exploiting these deviations from economic rationality.    

The real challenge for banks (and other financial services) is to develop products/services that incorporate these behavioural science insights.

For example:

Up to now, some (many) banks developed payment tools that harness the cognitive shortcomings of people when considering money matters.

These payment tools make payments easy and with a low level of pain of paying.

At first glance this is great. People spend more easily, they enjoy shopping, the merchants are happy because they sell more, banks are happy because they earn money etc.

Things aren’t as straightforward as they seem at first glance. Indeed, people enjoy shopping and a lot of purchases would not have been made if the pain of paying was higher. However, many people would like to be more moderate on their shopping behaviour.

Opening the gates to easy spending brings the joy of buying, but it also brings the regret (and anger) of over-spending.

Apparently the goals of enjoying spending and avoiding over-spending are antagonistic. But there’s at least one way of conciliating the two goals and developing payment tools that fit what people want.

The main challenge banks and financial services, overall, face is to become truly useful and not just more utilitarian.

In order to avoid obsolesce,

 Truly Consumer-Centered Banking Services

Need to Incorporate these
Behavioural Science Insights.

I gathered lots of intriguing insights and potential solutions on how to make banking services more human friendly in the seminar:

Re-Design Banking & Insurance.

Oh… almost forgot: It’s 2.5 hours long and very affordable, especially for banks ;)

Traditional Winter Payments and their Pain of Paying

When putting together the words “Traditional” and “Winter” the first thought goes to Christmas and New Year since these are the main events of winter and they happen each and every year. Naturally, both Christmas and New Year come with some expenses and subsequent payments. Every payment hurts and I believe that payments made for the usual Christmas and New Year purchases are less painful than are other payments. For Christmas and New Year people have money allocated for things such as gifts, food, booze (after all it’s a reason to party) etc. Moreover, Christmas and New Year most often come with joy and reasons to celebrate or at least party.

There are, however, other payments that are specific to the winter season and are completely unrelated to the holidays. These payments include paying (local) taxes, paying the regularization (balancing) for utilities such as energy, water etc., paying one-year fees for very necessary services such as sanitation (picking up the garbage) and sewerage. All these payments are due in the winter months (at least in some countries).

Naturally all these payments have to be made and everyone is more or less aware of this fact. However, these payments come with an increased level of pain of paying – the psychological discomfort experienced when making payments.

Let’s take the example of paying the regularization (balancing) for utilities bills. In The Netherlands (and in some other countries) for energy people pay a fix amount each month and at the end of the year a computation is made in order to see whether the individual paid more or less than she has actually consumed.  Not surprisingly there are quite some cases in which people consumed more than what was estimated. When the invoice comes it is a painful one. Energy is something we don’t see; it’s the electricity that powers my laptop, the heat in the room (in The Netherlands usually it is quite cold) and the electricity or gas that makes the cooking stove work. Moreover, when being informed at the end of the year that you need to pay more for something that you have consumed during the entire year, there is a feeling of paying for nothing. Those 400 Euros you have to pay extra include the electricity consumed by the light that you forgot to switch off in March. It simply feels awkward…

A very important factor involved in the pain of paying experienced in relation to these “traditional winter payments” is the way in which the payment is made. Let’s stick to the example with balancing energy bills. Usually in The Netherlands such bills are paid using the “Direct Debit” method which means that the amount due to be paid is withdrawn from the bank account of the client by the company that issued the bill. In essence, the payer does not have to do anything, except for making sure that there are enough money in her bank account, which can be quite challenging since a lot of money was spent on Christmas and New Year.

Now, imagine that this method of payment would not be available and the only way in which someone could pay this bill would be to go to one office of the energy company which is half-way across the city in winter weather and the payment can be made only in cash (bills and coins).

It is obvious that the level of discomfort associated with the payment is higher in the second case than it is when using direct debit.  

“Traditional Winter Payments” are annoying by their very nature. However, most people simply accept them as a given status-quo. Everyone realizes that energy bills have to be paid and that annual payments for sanitation and sewerage services are mandatory if one wants to have the benefits of civilization…  Minimizing the pain of paying associated with these payments is a worthy endeavor.

Take a moment and think of how other payments that are less vital for a civilized standard of living (having energy and sewerage) influence purchasing behaviour and customer satisfaction. Purchasing behaviour is influenced by many factors including the price, income etc. What is often ignored is the level of pain of paying associated with a purchase…

Take a look at My Training Programs on Pain of Paying

And

Psychology of Money

Thinking Money - Preview

Here's a brief preview of Thinking Money - workshop on the psychology of money I will give on the 29th of October.

For more about the Psychology of Money and how it influences decisions and behaviors related to money,

Join me in Thinking Money -Training on the Psychology of Money. 

What You Don’t See Can’t Hurt You - How Visibility of Payment Influences the Pain of Paying

Use your imagination and picture a market in the mid XV-th century in Europe. Farmers and tradesmen sell their products in the square of the city. Others want to buy and search for the best offer. At one point the buyer chooses one seller and buys, say wool. In exchange for the wool the buyer will give the seller a number of coins – money.

If we think about this transaction – wool for coins – we notice that it is a very visible one. The buyer takes the coins out of his bag (pocket) and gives them to the seller in exchange for the product. Putting things a bit differently, for the buyer it is impossible to not see the coins (money) going out of his pocket and going into the seller’s hand and pocket.

Nowadays things are a bit different than in the mid XV-th century. Now we can pay without seeing the money going out of our pockets and into the seller’s hand. We can use checks, bank cards, vouchers, bank transfers etc.   

The visibility of a payment – of money going out of one pocket and into a hand – influences the amount of pain of paying associated with a payment. Think of the following scenario: Linda goes out on a weekend day and wonders the streets of the city center. At one point her eyes are drawn to a shop window and she sees a wonderful pair of shoes. They look absolutely gorgeous and she goes into the shop and tries them on. Miraculously they do not only look great, they also fit close to perfect. Linda looks at the price tag and feels a bit of chill; the shoes cost 129 Euros. Linda is perfectly aware that she doesn’t really need this pair of shoes since she has already more than 15(0) pairs. However she felt in love with them. In her wallet she has three 50 Euros bills and her bank card on which she has more than 129 Euros.

Do you think that Linda will pay in cash or using her bank card?

Most likely Linda will use her bank card because by doing so she will not see the (quite large) amount of money going out of her purse and into the hands of the cashier. The bank card transaction represents the same thing as paying in cash… Linda will still have 129 Euros less and a wonderful pair of new shoes. However, Linda will not see the payment. She will experience less pain of paying by using her bank card.

Linda goes out of the shop happy because she got a wonderful new pair of shoes and feeling quite good that she still has 150 Euros in her wallet. She didn’t see the 129 Euros (price of the shoes) going out of her purse and this contributed to her experiencing a low level of pain of paying. She goes into the street and walks around with a bright face (due to happiness). After about two minutes Linda’s phone rings. She received an SMS which says:

“Your Bank Inc. informs you that a payment of 129 Euros was made out of your account to Fantastic Shoes Ltd. If you do not recognize this transaction contact Your Bank immediately”

How do you think Linda feels now? She paid with her bank card so that the payment would be less visible and decrease her discomfort of paying a large price for a pair of shoes. Now the bank informs her that this payment was made, thus making it more visible. In terms of pain of paying reduction, almost the entire benefit of using a bank card is gone. Linda’s face is no longer bright and a feeling of pain mixed with guilt (for paying 129 Euros for a pair of shoes she didn’t really need) go through her mind…

The bank introduced this SMS service to prevent fraud and if people would be perfect reasoning machines without feelings it would be a very useful tool for increasing the safety of using bank cards. However, people have feelings and it is no wonder that when Linda got home she unsubscribed from this service.

The learning from the story of Linda buying shoes is that the more visible (salient) a payment is, the higher the level of pain of paying is experienced. So if you want to increase the pain of paying you should make the payment as visible as possible. Similarly, if you want to decrease the pain of paying you should make the payment as less visible as possible.

Just as a note… the difference between levels of pain of paying experienced when making a visible and respectively a less visible payment will be smaller for purchases that are frequent (e.g. groceries) and planned (e.g. buying a new laptop). This is not to say that there is no difference, rather it is to say that the difference is smaller than in the case of impulse, unplanned (even unnecessary) purchases. 

For more about the Psychology of Money and how it influences decisions and behaviors related to money,

Join me in Thinking Money -Training on the Psychology of Money.