The Psychology of Saving

For more articles like this one visit hlb.com.au

If you received an unexpected windfall of $1,000, you would be as equally pleased as receiving an unexpected windfall of $2,000. However, if after receiving a $2,000 windfall you had $1,000 taken away, you would be disappointed even though you still gained $1,000.

This reaction comes from the tendency known as “loss aversion”, a cognitive bias suffered by humans. Social scientists have demonstrated that we are twice as sensitive to the unpleasant feeling of loss as we are to the pleasure of gain. Loss aversion is a helpful thing if you were stuck in the wild, but can cause challenges when managing money and saving. Saving money for a rainy day may not seem like a ‘loss’ but that’s how our animal brain interprets it.

You deprive your present self the enjoyment of spending now, so that your future self can enjoy it later. Even if you are fully aware of this tendency, why do we experience loss aversion? The truth is that intelligence and emotional control are not positively correlated and loss aversion causes problems even amongst the smartest people.

For example, self-employed people often receive gross earnings and are responsible for remitting tax and making super contributions. Their brain sees ‘$2,000’ and in the absence of rigorous self-discipline they can be at risk of overspending. When the tax office comes looking for their $1,000, they may need to borrow to meet their obligations. If you don’t properly manage your money, this can lead to problems such as having too much debt and not being able to repay your loans, as well as not being able to save or invest towards your financial future.

The good news is there are some simple strategies to overcome loss aversion and make saving easy. Automate — Arrange an automatic split of your salary between your day-to-day expenses and your savings. This could be an interest bearing account, managed fund or extra loan repayments — where the money goes is less important than the discipline itself. Remove discretion — Automating takes choice out of our hands, which means that we are not consciously deciding each month how much to spend or save. Hide the second $1,000 — Make sure your automatic saving happens on the day you get paid so you don’t miss what you never saw.

Understanding how our brains are wired and putting in place some simple disciplines not only dramatically increase the chance of success, but also provides the mental freedom to enjoy life with the money you do have.