The loss aversion effect — Why saving slowly makes sense for your financial wellness

Does it ever happen to you that you started a free trial of a consumer product but ended up becoming a paying customer? The reason might just be loss aversion — an information processing bias where the anticipated cost of losing seems much more significant than what it is in reality. From Netflix to Amazon, corporate giants use loss aversion to create a ‘missing out feeling’, for example in cases such as cancelling a month free trial subscription. What usually happens is that they use the trial period to create a need that didn’t exist before. Later with the help of a loose aversion, they will try to convince you to continue the subscription or face a ‘fear of missing out’ (FOMO).

In their work that led to a Nobel prize, Kahneman & Tversky noted that ‘loose loom larger than gains’. In other words, the magnitude of anticipation we develop about a future pain affects our present life choices more than a corresponding gain. In some estimate, a prospect of loss has twice the impact on life decisions than an equivalent gain (Novemsky & Kahneman, 2005). Loss aversion is created with a skewed magnifying lens in which people fail to anticipate their ability to cope with loses effectively. The effect is also known to hold people from pursuing what might maximize their happiness in the long run (i.e. breaking up from lousy relationship).

The effect of loss can feel as twice as that of the same gain

Interestingly, recent research has shown loss aversion may have an impact on not only how we perceive expectations but experience them (Boyce et al., 2013). In other words, if your experience of gain has a lesser impact than you have expected, the disappointing misalignment feeling can be the result of loss aversion.

The impact of loss aversion is stronger if your experience of gain is sudden, unexpected, or proportionally high.

To probe a little more on expectation versus experience misalignment, take the following example. Contrary to the ‘common sense’ belief, generally speaking, older people are more happier than younger ones. It is paradoxical as one gets old, s/he will more likely experience unwanted consequences of old age like poorer health and low income. Itturns out that older people tend to have a realistic expectation of life, hence effectively “narrow the gap between their life experiences and expectations” (Koedijk et al., 2012).

In the same line of thought, the loss aversion misalignment can also have implications on how we experience our financial well being; which is the theme of this blog.

‘Quick and Dirty’ — What is Financial well being?

Financial well being is “a state of security and certainty that financial matters are well organized for attaining individual goals” (Van Raaij, 2016, pp.127). Three components play a critical role with your financial well being: meeting financial commitments, resilience for the future, and feeling comfortable (Kempson et al., 2017). That last one revolves around how you feel about your financial state, regardless of your external situation. It is massively influenced by subjective measures, including how good you are in narrowing objective realities with expectations.

Loss aversion and your financial well being

Let’s imagine a scenario where you have a sudden and proportionally high increase in your monthly income. It is true that such an income change can have a positive impact on your ability to meet your financial commitments and to a degree, your resilience for the future. A peak on your income might also create a feeling of financial comfort.

But research has shown that we might be overestimating the positive effect of a dramatic income increase toward our financial well-being. Such an increase might even have a negative fallout for our wellness. Boyce et al. (2004), for example, established that loss aversion could negatively impact the experience of financial well being because of the loss aversion . The argument is that we might have a higher expectation of financial wellness as a result of income increase that will not be materialized in the level we expected. In particular, this unfulfilled expectation adversely affects one of your financial well-being components — feeling of financial comfort — and ultimately, your overall financial well-being. There seems to be no magic pill to avoid loss aversion.

The good news is that there is a way to prevent a mismatch between expectation and experience when it comes to financial wellness. Consistently stashing away a small portion of your income can increase your financial well being while keeping expectation at bay. The reason behind this assertion is that a slow and long-term but consistent rise is less likely to create a high expectation. Boyce et al. (2004) concluded that financial well-being “may be best served by small and stable income increase” as it avoids the impairing impact of loss aversion.

Save slowly to experience financial well being

In every aspect of life, loss aversion plays its trick on us by creating a gap between life experience and its amplified expectation. Steady and slowly increasing positive experiences might sound unfulfilling or out-right boring, particularly in our 21st-century, where only fast and ‘exciting’ activities are counted as a positive experience. But, when it comes to financial well being, a small and constant flow of saving is a successful way to beat loss aversion.

‘Taking your time’ to save is a remedy to loss aversion in the context of financial well being

Here are five tips that help you to ‘trick’ loss aversion and save steadily:

Automatic saving

Automatic saving/transfer saves you a lot of cognitive effort, whether it is about deciding to save this month or how much you want to save. An automatic transfer needs a one-time setup, and voilà you are done. You might want to revisit your saving amount every three months. If, for example, you have a habit of saving $400 per month, you can save up to $4,800 a year or $24,000 in five years. You would see the steady increase in your saving — hence you won’t be affected by loss aversion.

Save money from your everyday expenses

This one is actually about playing the loss aversion effect to your advantage. For example, you might spend about $30 for a couple of coffee outings per week. Now that is a loss of about $1500 per year and $7500 per 5 years. If you have the habit of annualizing your ‘negligible’ expenses, you could suddenly see how much money you spend that could be in your savings.

Now think of all those habits you may have, whether it is for nicotine or Friday night outings. Annualize these expenses by a year, then by five or even by ten. With added effect of loss aversion, it is painful. What you can do might be to set up a goal to decrease, for example, a packet of cigarettes per week, and send the ‘saved’ money right into savings account. It can make you both healthy and prosperous.

Pay yourself first

Think of your monthly savings as one of your bill to pay. It is a due payment that must be addressed each month, just like any other monthly bill such as rent.. That way, it becomes something you accustom to pay every month, but in this case, to yourself. Consistency and time is the key here, rather than the ‘bill amount’. Make sure to pay your savings account at the same time as you pay your other bills, most likely right after your monthly income.

Use personal finances technology

We are living in an era of open banking. That means, whatever your choice of a tech tool, it can access your bank(s) account to track your spending habit. Do some research on these tools, and see which one fits your need/your geographical location. Examples of such personal finances include mint, YNAB, Tiller, countabout, pocketsmith or TINK. There are others like Moneybox that let you invest in stocks. Most of these apps come with no cost, but it is also essential to see if any additional fee is involved, especially with the ones that let you invest in bonds and stocks.

Budget

This last one is not much of a saving tip, but an integral element that keeps your commitment of saving intact. If you are not good at managing your expenses, it is more than likely that you ended up taking a few hundreds from your saving. As the YNAB folks would say, every dollar counts and you need to give each of them a job. The more detailed your budget is, the better. Make sure that your saving accounts are a ‘no-go-zone’ for daily expenditures. You might use some of the personal-finance tools or the old-good table book-keeping. Protect your saving accounts by all means, and the monthly budget management is a key to that effort.

So here you have it. You can certainly avoid the loss aversion effect when it comes to your financial well being experience by using steady saving.

Maybe now, it is time to log in to your bank account and set up that monthly automatic saving transfer?