A strange thing can happen if we lose a job then get a new one that pays less.Losing a €30,000 a year job then getting one that pays €25,000 can be seen positively – after all a €25,000 salary is much higher than no salary at all.But on the other hand, it can be seen negatively, as a loss of €5,000 a year.
Any “loss” or “gain”, be it financial or otherwise, will be compared against a reference point: expectations or the status quo. What’s important is that studies suggest that people – and organisations – can reset reference points and, when it comes to money, this might just change the way we spend and save.
It’s all in the presentation
We might like to think that we fully control the way we think about a situation, but, perhaps surprisingly, the way that the situation is presented will play a part too. Consider your likelihood to agree to a medical procedure that has a 10% fatality rate over one that has a 90% success rate. The latter sounds much more appealing at first glance, even though with some reflection it is clear that these are the same risk.
This effect of presentation is known in technical terms as framing, and the Nobel Prize winning psychologist Daniel Kahneman and his late, long-term collaborator Amos Tversky spent decades studying framing and related phenomena.
The framing effect is important because the influence isn’t just random; it is systematic, which means that we can predict how a change to the presentation of information can shift people’s behaviour and decisions.
The prospect of losses
In the late 1970s, the pair published work on prospect theory, a challenge to the rational choice theory that is still used in many economics classes and discussions about public policy.
One of the main points of prospect theory is that people tend to be loss averse – in other words, they feel the pain of losses more so than they feel the pleasure of an equivalent gain and go out of their way to avoid feeling that pain. But as explained earlier, whether a situation is viewed as a loss or a gain might depend on the reference point. And, as the earlier example of getting a new job that pays less than the last one illustrates, the reference point is not fixed – it is whatever point against which we are comparing a new situation.
So how can a reference point be reset and used to our advantage when assessing personal finances?
One suggestion from a reader of the Nudge blog is to reframe credit cards bills to shift the reference point. Instead of listing the remaining credit available as an anchor to spend up to ("I have another €90 to spend before reaching my €1,000 limit”), the credit card bill could show the balance and the limit as negative (balance is - €910 and limit is - €1,000). The idea here is that the negative number evokes a loss frame and, in an effort to avoid or mitigate this loss, we will work “up” towards a zero balance.
Similarly, when trying to save up for something with a savings goal in mind, purchasing decisions can be reframed. If tempted to shop for new clothes, think of buys as a loss from a savings pot (rather than a gain to a wardrobe) to provide a fresh perspective on whether the item is worth it. An idea for banks might be to reward savers with their interest upfront, remaining in the saver’s account if they meet the set criteria. If the criteria are not met, the bonus interest would be revoked, motivating the saver to stay on track and achieve their saving goals.
So how will you use knowledge about framing, loss aversion, and reference points to your advantage?