Understanding the Emotional Cycle of Your Financial Decisions
It can be increasingly difficult to separate emotions from your finances, especially when the goals are emotional in their own right: buying your first house after your divorce, helping send your daughter to college, having the freedom to make choices in line with your values, or just retiring on time.
Money is never just money for so many of our clients. Money represents financial freedom, hope, and comfort, among other emotions. And that’s perfectly normal!
That’s why we always encourage investors to understand the psychology behind their personal finance and investment decisions. We are all individuals, after all, but our responses to the ups and downs of the market, for example, tend to be similar.
According to psychologists, emotions drive 80% of the decisions we make throughout our lives. Practicality and objectivity, on the other hand, only represent 20% of our decision-making processes. That’s because the feeling part of our brain tends to be much faster and much more impulsive than the thinking side of our brain; the feeling part of our brain is also the default decision-making system in our brain.
Think about it this way: how many times have you justified a decision by saying “It feels right”?
Personal finance should be a matter of math, but sometimes, it comes down to emotions and behaviors. One example: In 2018, when the S&P 500 lost 4.38%, analysis found that the average investor lost more than double that – around 9%. Why? Because they acted impulsively when the market declined.
These types of impulsive decision-making processes can have expensive consequences. Let’s dive into the many different ways that your own personal influences affect your financial decision making.
Have you ever checked your portfolio, only to see the stock market has dropped? The stock market has endured its fair share of volatility since the pandemic struck, with plenty more to come. When you log in to find your stocks have dropped, you may find yourself experiencing an emotional rollercoaster.
Should you sell? Should you stay in the game, and sell later?
It’s hard to think about the long game when you start to panic. Impulsive decisions made in the heat of the moment can wreak havoc on your investment strategies – and your overall financial big picture.
Impulsive decisions may come from the stock market, of course. But they can also be the result of other external factors, like strong emotions relating to a personal event, like an upcoming vacation that you need to budget for – and you’re panicking, or other recent current events like the war in Ukraine.
The impulsive buying and selling of stocks based on your emotions is just one part of the emotional cycle of investing. When we invest based on emotions we are acting directly opposite of the logic of the market. When the market is going up, we feel amazing! People think, “This is so easy! I can quit my job and trade full time!” Then, when the market inevitably goes back down, people generally panic and run around like Chicken Little saying, “The sky is falling! We will never recover!” But, when we look at what is happening to prices in the market we learn that we should tell our emotional brain to shut up. When the market is rising, prices are going up. When the market is falling, prices are going down. The old adage is: Buy Low, Sell High. But our emotional brain is screaming, “Buy High, Sell Low!” We can all agree in the cold light of day that we want to Buy Low and Sell High, but our emotional selves will usually short circuit this.
Picture this: you find a $100 bill on the street.
Are you going to spend that cash, or put it into your savings account and invest it?
The answer rests in the psychology of behavioral finance, which looks at our brain and its connection to managing and investing money.
Spoiler alert: most people will spend the $100, even if they consider themselves to be more prudent with their finances. Mental biases can affect the way we spend money and handle our finances. Consider these types of bias:
- Mental accounting: People treat money differently depending on where it came from – and what it’s supposed to be used for. This gets tricky, for example, when people have a chunk of money saved for their house, but incur medical expenses. Instead of using the money set aside for their house, many people would rather keep that money tucked away because it’s already been allocated for the house and go into debt for the medical expenses. If you have to pay over 20% for medical debt on your credit card, does it make sense to keep money in the bank earning less than 1%? Mental accounting can cause you to make less optimal decisions. Instead of thinking of your money in buckets, look at your assets from a big picture point of view.
- Loss Aversion: Loss aversion is a personal bias toward avoiding losses over seeking gains. One study found that people are much more sensitive to losses than comparable gains when they make decisions. People tend to magnify losses. For example, if you lose $1, your brain tells you you’ve lost $2. This can cause you to react emotionally to a loss that is not based in reality and make poor financial decisions. Further, loss aversion can lead people to avoiding small risks – even when they are worth it. It’s why many people will save their money instead of investing it.
- Overconfidence: This one is pretty straightforward: we tend to see ourselves doing or being much better than we actually are. Studies have shown that overconfident investors don’t manage risk properly. But overestimating your abilities can lead to rash or poor decisions. Even professional money managers fall prey to this. A survey of over 300 professional money managers found that 74% of professional fund managers thought they were above average. Mathematically only 49% of money managers could be above average. This means at least 24% of those managers were suffering from overconfidence.
Understanding the Psychology of Personal Finance
When we understand the psychology behind our decision making, we can take steps to overcome the bias and the impulse decision making. If you’re looking to make smarter financial decisions – and take the emotion out of it – get in touch with us. We can help you build a plan best suited for you, your needs, and your goals.