My finances, my projects, my life
March 30, 2023

Rounded numbers can ruin our finances

Whether managing a budget, saving or spending, we are all faced with making calculations on a daily basis. Many of us often resort to broad-brush estimates and rounded numbers to limit the effort required and to avoid mistakes. This isn’t necessarily a good idea.

In our daily accounts, it is of course easier to deal with figures such as 10 or 50 rather than 9.67 or 54.38. By the same token, it’s practical to be guided by banking apps that round up expenditure to the next euro for automatic savings plans or to make loan simulations based on monthly repayments of amounts that can be easily included in our budget. All of these rounded numbers make life easier because they reduce our mental workload. Unfortunately, they may also damage our financial health over the long term.

If you’re a regular reader of myLIFE, you will know that our cognitive ability is a limited resource, just like our physical stamina. This means we tend to look for the solution that takes the least effort in the short term in order to conserve our cognitive energy. This tendency is often useful but may also be the source of suboptimal decisions or even errors.

We apply the first principle of least effort to completing tasks and resolving problems.

The principle of least effort

The theory of least effort was first formulated in 1949 by George Kingsley Zipf, a Harvard linguist. At the time, he was conducting research on the statistical study of the frequency of the use of words, and identified a first principle at work in all human action, including verbal communication: we seek the course of least effort to complete a task or resolve a problem, in the present or in the future.

As well as the linguistics research of Zipf or, more recently, other research conducted on the British National Corpus, the validity of the principle of least effort has been verified in other fields such as psychology, sociology, economy, marketing and mathematics. Studies have shown that rounded numbers appear more frequently in texts of all types than other figures, as they are easier to memorise and process, and make mathematical calculations easier. Whether making a charitable donation or a monthly transfer to our savings account, rounded numbers make our daily calculations easier. They give the impression of simplifying the world around us. If you need convincing of this, just think of when you fill up the petrol tank – who hasn’t tried to stop on a round number such as EUR 70 and felt really happy with themselves when they manage it?

Round numbers act like magnets on our brain, which looks for them in order to simplify life, or uses them as limits, for example when we’re out shopping. This cognitive preference is well known to marketing experts who tend to offer prices that end in 99 such as EUR 99 or EUR 8.99. This is called the anchoring effect of the left digit.

Why is this technique used? Quite simply, because our brain will look to simplify things and place excessive important on a price of EUR 99, exaggerating how much more advantageous this is versus the magic limit of EUR 100. Our brain will therefore tell us that the purchase is acceptable as it is below the limit we have set, and it will reject another similar object priced at EUR 101 even if this item better matches our expectations and requirements. In this case, a rounded number leads us to prefer a purchase that is less relevant for irrational reasons.

A rounded number may lead us to prefer a purchase that is less relevant for irrational reasons.

These pricing strategies that play on our largely unconscious preference for certain numbers may pose a risk to our budget if we are not aware of the influence they exert over our decisions.

Useful info: when making a purchase, avoid focusing solely on the price of something and always try to consider the relationship between price and quality based on your real requirements.

Simplicity can damage us over the long term

Round numbers may have even more damaging consequences if we overemphasise their importance in a long-term financial strategy. Let’s have a quick look at the example of a young professional who decides to make an automatic monthly transfer to his savings account to build a nest egg for his retirement. He decides to make a transfer of 5% of his monthly salary of EUR 3,000, i.e. EUR 150 per month. This figure pleases him because its simple, sounds about right and is an amount he can afford. If we take a simplified approach and assume that the amount of the monthly transfer remains fixed and the capital earns no interest, our professional will have saved EUR 72,000 at the end of 40 years.

But was 5% the right percentage? It’s a number that sounds right and is easy to remember. But what if he had realised that instead of a round number, in reality, he could put aside 6.5% (EUR 195) of his salary instead of 5%? Based on this scenario, he would have EUR 93,600 after 40 years – 30% more than in the first scenario. And had his investment been earning interest, this difference would have been even greater in absolute terms thanks to the impact of compound interest. With an annual interest rate of 2%, after 40 years, he would have a pot of EUR 109,716.64 in the first scenario and EUR 142,631.63 in the second.

Using round numbers for the sake of ease when building a financial nest egg for the long term can have a considerable impact over your working life.

Using round numbers for the sake of ease when building a financial nest egg for the long term can have a considerable impact over your working life. This is particularly true if we consider that in real life, your salary is very likely to rise and amounts saved will earn interest. Choosing to stick with 5% because it’s easy or opting for a slightly higher amount that is affordable will make an enormous difference when you come to retire.

Useful info: it’s important to establish your financial strategies based on what you can really afford rather than going for the easy option of round numbers.

Round numbers and real costs

Taking the easy option when it comes to decision-making can not only stop us amassing money over the long term but may even cost us money. Let’s take a look at our ongoing loans. Can you see round numbers like EUR 200 or EUR 400 for monthly repayments? If this is the case, don’t worry, you are not alone. A study recently conducted by MIT researchers showed that most people prefer monthly payments in multiples of 100.

This study demonstrated that people who prefer to establish their monthly budget with round numbers automatically train their brain to think in terms of monthly instalments. Result: when it comes to choosing the terms of a loan in the future, they are primarily interested in the monthly repayments on the loan and generally opt for the lowest round-number monthly amount. They will therefore focus on numbers such as EUR 200, 300 or 400 because they think these figures are manageable to keep within their monthly budget. By thinking in this way, they obscure the fact that they are choosing terms that may be unfavourable for them. By prioritising lower round-number monthly repayments, they choose loans with a longer term, which are therefore more costly due to the longer interest rate period.

The MIT researchers found that this recurring tendency to smooth monthly instalments on car loans applied to over 2 million people. And this type of behaviour was just as prevalent in better-off households with the financial resources to increase the amount of monthly repayments and thus reduce the total cost of the loan by shortening its term!

Useful info: the cost of a loan is not determined solely by the level of monthly repayments. Its term and the associated interest rate are major elements in calculating the real cost of debt, especially when borrowing over long periods of time.

If round and rounded numbers make day-to-day calculations easier in many situations, we should avoid giving in to the temptation of oversimplification which can be very costly over the long term. Your banker can help create a long-term strategy that avoids such pitfalls using real simulations based on your actual financial situation. Consider yourself warned!