Are you making good financial choices?

In 2015, US insurer Prudential ran a series of ad campaigns highlighting the biases that lead people to make poor financial decisions. These biases, known as “heuristics”, are mental shortcuts that enable us to make quick decisions that are practical but not necessarily optimal.

Heuristics served our Neanderthal ancestors well back when decision making was simple. For example, if Ancestor Joe wrongly assumed that a strange red fruit was poisonous, he would have missed the opportunity to enjoy a delicious snack. In modern times, decision making is far more complex and the stakes are higher, particularly in financial matters.

I was recently reflecting on decision making in the context of insurance. Consider these facts: about 90% of Kiwi motorists have car insurance, whilst just 25% of income earners hold income protection cover. Why the gap? The Financial Services Council offers some possible explanations:

  • Kiwis are more familiar with car insurance than income protection insurance;
  • Reliance on ACC for income support; and
  • Perception that income protection cover is too expensive.

Another possible explanation is the concept of “loss aversion”. Studies have shown that the pain of a loss is twice as great as the pleasure of a gain. In other words, people are more worried about paying for damage to their car after an accident than the risk of losing income if they are unable to work due to injury or illness.

Don’t believe me? Imagine how much more likely you would be to purchase income protection cover if you received your annual salary at the start of each year and you were required to pay it back if you were unable to work.

Another heuristic that leads us to make poor insurance choices is “availability bias”. We tend to worry about things right in front of us. A famous study by the founders of Behavioural Economics, Daniel Kahneman and Amos Tversky, showed that people assessed the risk of an earthquake in California to be greater than the risk of an earthquake in the United States. The study exploited the fact that earthquakes commonly occur in California and are often reported on by the media. Therefore, it’s not surprising that we tend to be more concerned about car accidents, which most of us are regularly exposed to, than disablement.

You can check out the Prudential ads here. And to avoid potentially costly financial mistakes, it pays to get some good advice.