Acclaimed London-based psychologist, writer and broadcaster, Claudia Hammond, shares some compelling insights on the psychology of money and how we can all improve our spending habits.

Did you know it was often easier to ‘trick’ somebody into saving more than having a planned, rational discussion with them about the pros and cons of saving more for their future spending needs?

It’s a ploy that accomplished psychologist and behavioural finance expert, Claudia Hammond knows only too well.

“Our relationship with money is far more complex than we might think. We’re not always good at knowing how to use money and how to make the best decisions about it,” Claudia says. “By using the latest research – from psychology, neuroscience and sociology – we can look at the things we can do differently in our approach to money, and so, avoid some of the mistakes and assumptions we might be making about it.”

Claudia believes that financial planners are well positioned, as trusted professionals, to educate and encourage a stronger culture of fiscal discipline with their clients, and the key to unlocking this is psychology.

“We don’t always make the best decisions when it comes to prices and the cost of items. We all tend to think we’re better than others when it comes to spotting good deals, just in the same way that most of us think that we’re better drivers. But, statistically, we know that’s not the case. And so, it’s the same with money,” Claudia says.

“A common cognitive mistake we make is what’s called the ‘endowment effect’. It is well established that we over-value things that we already own. So, if we’re going to sell something that we own, we want to get more for it than it’s probably worth. And this tends to mean that people want to hold onto their investments and sell them for more than is realistic. It’s behavioural finance.”

Another cognitive mistake that Claudia identifies is ‘loss aversion’.

“We all hate making losses. So, we go to a lot more trouble to avoid a loss than to get a gain. This is where financial planners, by understanding client psychology, can change the behavioural approach of their clients to finance,” she says. “When you talk to your clients about risk, it’s also important to talk to them about their attitude and aversion to loss.”

And there’s also ‘relative thinking’.

“Behaviourally, we go to a lot more effort to try and get a good discount on something that is cheaper than something that’s expensive, because we always look at discounts as a percentage of the whole thing,” she says.

“So, if something costs $60 and we can save $20 on that, then we are pleased by it. But we don’t bother saving $20 on something that costs $500 or $1,000, like a holiday. We don’t bother trying to save that amount, even though every $1 saved counts.”

Another interesting aspect in relation to financial planning that Claudia identifies is people’s attitude to ‘saving’.

“There’s the ‘budget fallacy’, where we think that in the future we will earn more and save more, and we will be better at spending less. But, in fact, there’s no reason why you’ll suddenly get better at saving or suddenly get better at spending less, if you haven’t already changed your practices around that,” Claudia says.

“So, it’s about changing people’s attitudes towards what they want to save and how much they think they should save in the future. Some people think of the future as being much further away than other people do. So, there’s this perception factor to deal with.”

Claudia believes planners can use subtle ‘tricks’ to deal with this perception factor that will help change the way clients view the future in terms of their spending and saving habits.

Save more tomorrow

One such ‘trick’ is to break down target periods. Claudia explains: “If your client is going to retire in 10 years time, you can get your client to think of this period in terms of retiring in 3,652 days, instead of 10 years. By breaking down target periods into smaller measurements, in this case – days, it feels as if the end period is so much closer than using larger periods of time, like years.

“So, there are lots of ways that planners can reframe situations to make their clients think differently.”

A clever savings experiment done by American economist and behavioural finance expert, Richard Thaler, revolves around a plan where a person commits to saving more each time they receive a pay rise in the future, because then they are committing future money rather than money now.

Thaler believes nobody wants to have less money to spend now, but will behave differently when they receive a pay rise, as saving a little of this extra money doesn’t seem like a loss.

Thaler says a lot of behavioural finance issues come back to ‘loss aversion’, so by making things feel like it’s not a loss, is a great way of changing the behaviours of clients towards saving.

According to Claudia, Thaler designed a very clever savings plan called ‘Save More Tomorrow’, where people commit to saving a certain percentage each time they have a future pay rise.

The concept is rather straightforward – people commit to saving most of next year’s pay rise or salary increase, instead of cutting their spending now. The simple elegance of this plan is backed by a number of important behavioural finance concepts, including aversion to a loss of current lifestyle and taking advantage of people’s tendency towards exaggerated discounting to make (future) saving less painful.

While there are some real challenges to implementing a ‘Save More Tomorrow’ approach, Thaler believes it does raise the question of whether the traditional approaches to retirement advice, like ‘save more and spend less’ or ‘save X per cent of your income every year’, are due for a radical rethinking.

According to Thaler, by focusing on saving more tomorrow – and by not spending more tomorrow – planners can actually find a better path to guide today’s future retirees towards better financial success.

“The ‘Save More Tomorrow’ plan has been very successful and many people have managed to save so much more by implementing this plan, than they managed previously. So, committing to saving future money, rather than reducing spending now, is a great idea that actually works,” Claudia says. “It’s all about how you approach the psychology of money.”

Behaviour

Claudia says psychology research supports the presumption that people respond differently to money and saving – whether that be for retirement, a ‘big ticket’ purchase, or the kids’ education.

“It’s definitely the case that some people are just better at using their money than others,” Claudia says. “We tend to be poor at some of the decisions we make. We think we’re making good decisions, when learnt behaviours prevent us from doing that.

“It’s also the case that people have very different attitudes to money. Some of these attitudes will come from what people first learn about money – whether it’s learnt behaviour from their parents at home, at school or in the workplace. We have very different ideas as to what counts as a necessity and what counts as discretionary. This learnt behaviour all comes into play as to how people save, spend or invest their money in the future,” Claudia says.

“So, this is where financial planners can help clients to look at their individual psychology and attitude to money, and so help their clients to work out what is best for them, enabling them to plan for their own financial wellbeing.

“Ultimately, by better understanding the psychology of money, practitioners will be able to better help their clients make disciplined decisions about their financial future.”