Behavioral Finance: Effects of Anchoring, Mental Accounting and Gambling on Our Clients’ Financial Decisions

Written By: David Cay

Something new is being addressed in financial markets: behavioral finance. One of the main insights from behavioral finance is that not all people are rational. It is my belief that frankly no one is financially rational, myself included. Here are some tools to help clients and communities understand three behavioral finance concepts: anchoring, mental accounting,and gambling, along with suggestions on how to overcome each.

Anchoring

Using our representational map, humans give something of value an expectation of cost. We may or may not realize it, but anchors are everywhere and frequently we are set up to be fooled. As counselors, we preach to our clients and communities that the sale price is the price. Never look at the manufacturer’s suggested retail price or MSRP. The MSRP sets an anchor and anything less than that cost is perceived savings.

I typically use the department store comparison for anchoring examples. You can purchase a fashion brand shirt that retails for $129.98. That shirt on sale for 60 percent savings gets you the shirt for $51.99. There is a regularly priced shirt for $29.99. Many of us will opt to pay for the fashion shirt and be thrilled with how much money we saved. But the reality is we could have purchased a shirt that would have adequately clothed us for 40 percent less than the fashion shirt.

We can establish our own anchors. Take emotion and brands out of the mix, compare value, and read reviews. We often give more durability and value to known brands in error.

Mental Accounting

Every year I become frustrated with clients who perceive that tax refunds are free money. I have assisted in budgets and seen every hard earned cent put to good use. Then I will hear something like this from that same client: “The tax return is coming in a month!  It’s free money, let’s spend it on something fun.” Or worse: “Let’s get that money now by paying a percent to a tax professional. How much do we pay? It doesn’t really matter since it’s free money!”

By learning more about how behavioral finance influences spending, we can better coach our clients and communities.

If I suggested that a substantial figure in a budget should be given to me for no real reason, I would likely be dodging bullets! It doesn’t matter if it’s a tax return, inheritance, or a ten dollar bill found in the park. If it is mentally unaccounted money, its free and the value to us is much less than money we earned. It all comes back to not allowing any of our funds to be worth less than the funds we earn. The tax refund is money overpaid through over withholding of taxes. Your client is getting back money that should not have been given to the Internal Revenue Service interest free. Every single cent of that tax return is money your client earned. It isn’t a bonus.

Gambling

I consistently have clients who gamble as a form of investment or worse, retirement planning. There is a mentality that it’s a matter of when, not if they will win.

To show how unlikely that is, I have a fun exercise to use in a class or even in a oneon-one setting. It goes like this: “I have a one hundred dollar bill and will set it here as a prize. I will draw a name from a hat to be the winner! Who would like to put their name in the hat? Raise your hand.” This gets everyone’s attention and I have a room full of eager participants. “Let’s play a new game. I will need five dollars from each person. This is pretend, so please pretend you just happen to have an extra five dollars today. I will add each paid person’s name into a hat and the one winner gets all the money.” I typically get less participation. I ask those who are not playing why they are not playing. Typical answers are that they don’t gamble, or the odds are too high. “One more game, everyone who wants to play, pays just one dollar. I will draw a name from the hat and the winner will get half of the money. Who wants to play?” I am asked what happens to the other half of the money; of course I get to keep it.

This raises questions about fairness and what I am doing to earn my half of the money. This is where I firmly throw the lottery under the bus. Look at the odds of every scratch ticket. Add together the estimated participation and all the prize money. You will certainly conclude that the winner does not get all the money put into the game. Now look at the odds of winning the Powerball: 1 in 292 million. The odds are so extreme that even with millions playing the game, very frequently there is no winner at all. I conclude with; “So if you won’t give me half the prize money, why give half or more to the lottery?”

Educating and teaching about budgets and spending plans is part of the equation. By learning more about how behavioral finance influences spending, we can better coach our clients and communities. The intention of this article is to give you a starting point in which to start the conversation. Once illogical spending decisions are identified, they are much easier to address and correct. Start today by asking yourself honestly: have I ever spent money with emotion instead of logic? You can then apply more scenarios and understanding to further assist with how to start someone on a budget or spending plan, and more importantly, how to stay on one and succeed!