As humans, we are programmed with mental models that guide us in making decisions and taking action. Mental models are cognitive processes that our brain goes through when thinking, knowing, remembering, judging and problem-solving.
Some models support us in making the best decision – such as saving in the most optimised manner, seeing a situation for what it really is or managing our money better. Unfortunately, some cause us to make bad decisions and waste money, not be prepared for events that are to come, and act even when it is not best to do so. These have a direct impact on the life you have today and the life you will have in the future.
Understanding yourself and the drivers affecting your decision-making is key to improving your financial position. Below, we share some of our sometimes unhelpful mental models and offer suggestions on how to address them and reduce financial wastage.
"Overconfidence can make you overestimate your abilities and knowledge, leading to poor decisions. "
Believing You Are More Capable Than You Are
Overconfidence is displayed by those who feel more capable of doing or judging something than they are and can cause people to take more risks. Overconfidence can make you overestimate your abilities and knowledge, leading to poor decisions.
Consider that you are leaving your job and joining another company that uses a different pension provider. A friend had suggested that you could consolidate your pensions into one pot, contribute to that from now on and ask your employer to do the same. If you have never looked at pensions before, it is likely that you will not know what the right decision looks like. When moving pension providers, you must consider the fees they will charge, the amount you are transferring and select the best provider for you. Your risk profile is an important factor, as well as the range of funds available and the benefits attached to your pension.
Overconfidence tip: If you are about to make a decision that could potentially have a significant impact on your life, speak to your employer, a finance professional or your bank who may be able to point you to a trusted advisor.
Lacking Awareness of the Impact of Your Emotions
The empathy gap causes you to underestimate the impact your varying emotional mental states will have on your future behaviour. For example, when you are in a ‘cold’ state, and not influenced by emotion, you are likely to make a rational decision. This may look like deciding that you won’t spend more than £20 when you go out to meet friends for a drink that evening. But when you are out at the bar and in a ‘hot’ state – excited, having a good time and socialising - you end up buying 4 rounds for the entire group, paying much more than £20! Many research cases have confirmed this, and an interesting study shows that those in an emotionally charged state are more likely to underpredict the value and desire they would have for a cigarette at a later time.
“We do this as we think that by just 'doing something' we may reduce the ambiguity and create certainty and control.”
Empathy gap tip: As much as you may have had good intentions, as humans, we are heavily impacted by our emotions. Instead of relying on willpower and self-control alone, put systems in place to stop you from doing what you don’t want. This may include not carrying a bank card with access to all your money, or deleting payment apps from your phone.
Feeling as Though You Must do Something
Action bias causes us to act and ‘do something’, and not consider whether the decision is good or bad. Research looking into the influence of previous event outcomes (negative, positive, or absent), showed that the level of regret following negative prior outcomes, is higher when attributed to inaction - potentially acting as a motivator for action.
Action bias explains why people panic buy during a pandemic or, as we saw in 2021, filled their cars up with as much petrol as possible when news surfaced about a shortage of truck drivers. These actions occurred although the information provided to them suggested this was not necessary. We do this as we think that by just 'doing something' we may reduce the ambiguity and create certainty and control, and we fear missing out on what others are doing. This can be damaging, as with the occurrences above - we end up spending much more of our money in one month and not being prepared for the future costs to come.
Action bias tip: To avoid acting irrationally and possibly making bad decisions, you will need to learn to not act on impulse, and instead take time to rationalise all the options available. This process requires you to slow down, grab a pen and paper, and assess the pros and cons.
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This article is for informational purposes only. It should not be considered Financial or Legal Advice. Mind Over Money assists you in making better economic choices, improving your wealth and building financial confidence. Consult a financial professional before making any major financial decisions.