This article shares some insight into three mental models that interact with how we make financial decisions. There are many more, of course, but these are some that I regularly witness with the people I work with.

Psychologically, we are programmed with mental models that guide us in making decisions and taking action. Mental models are cognitive processes that our brain goes through when thinking, knowing, remembering, judging, and problem-solving.

Some models do a great job in supporting us in making the best decision — such as saving in the most optimised manner, seeing a situation for what it really is or managing our money better. Unfortunately, some cause us to make bad decisions and waste money, not be prepared for events and act even when it is not best to do so — annoying. These have a direct impact on the life you have today and the life you will have in the future.

Understanding yourself and the drivers affecting your decision-making is key to improving your financial position. Below we share some of our sometimes unhelpful mental models and offer suggestions on how to address them and reduce financial wastage.

#1 - Believing You Are More Capable Than You Are

Overconfidence is displayed by those who feel more capable of doing or judging something than they are and can cause people to take more risks. Overconfidence can make you overestimate your abilities and knowledge, leading to poor decision-making.

Imagine that you are leaving your job and joining a company that uses a different pension provider. A friend had suggested that you could consolidate your pensions into one pot, contribute to that from now on and ask your employer to do the same. If you have never looked at pensions before, it is likely that you will not know what the best decision looks like. When moving pension providers, you must consider the fees they will charge, the amount you are transferring and select the best provider for you. Your risk profile is also an important factor that must be factored in.

Overconfidence Tip:

If you are about to make a decision that could potentially have a significant impact on your financial life, speak to your employer, a finance professional or your bank who may be able to point you to a trusted advisor.

#2 - Lacking Awareness of the Impact of Your Emotions

The empathy gap causes you to underestimate the impact your varying emotional mental states have on your behaviour. For example, when you are in a ‘cold’ state, and not influenced by emotion, you are likely to make more rational well-thought-out decisions. This may look like deciding that you won’t spend more than £20 when you go out to meet friends for a drink that evening… The issue arises, when you are out at the bar and in a ‘hot’ state — excited, having a good time and socialising, you end up buying 4 rounds for the entire group, paying much more than £20! Many research cases have confirmed this, such as a smoking-related study — showing that those in an emotionally charged state are more likely to underpredict the value and desire they would have for a cigarette at a later time.

Empathy Gap Tip:

As much as you may have had good intentions, as humans, we are heavily impacted by our emotions. Instead of relying on willpower and self-control alone, put systems in place to increase friction and stop you from doing what you don’t want. This may include not carrying a bank card with access to all your money or deleting payment apps from your phone.

#3 - Feeling as Though You Must Do Something

Action bias causes us to act and ‘do something’, and not consider whether the decision is good or bad. Research looking into the influence of previous event outcomes (negative, positive, or absent), showed that the level of regret following negative prior outcomes, is higher when attributed to inaction — potentially acting as a motivator for action.

We do this, as we think that by, just ‘doing something we may reduce the ambiguity and create certainty and control.

Action bias explains why people panic buy during a pandemic or, as we saw in 2021, filled their cars up with as much petrol as possible when news surfaced about a shortage of truck drivers. These actions occurred although the information provided to them suggested this was not necessary. We do this, as we think that by, just ‘doing something’ we may reduce the ambiguity and create certainty and control — we fear missing out on what others are doing. This can be damaging as with the occurrences above; we end up spending much more of our money than intended and not being prepared for the future costs to come.

Action Bias Tip:

To help reduce the likelihood of acting irrationally and making bad decisions, you will need to learn to not act on impulse, and instead take time to rationalise all the available. This process requires you to slow down, grab a pen and paper, and assess the pros and cons.

Summary

To round up, we’ve highlighted three mental models that interact with your financial decision-making: overconfidence, action bias and the empathy gap. The route to becoming sharper with how you make choices requires increased self-awareness by assessing the options in front of you, adding friction to limit bad choices and seeking external guidance.