Money is energy. It is a current. It is an intricate system of emotions, choices, and behaviors. Understanding the psychology of money is critical because it directly influences how we manage our finances. In this post, we will dive deep into how emotions like fear, greed, and happiness influence your financial decisions. We’ll also discuss strategies to keep emotions out of financial decisions.
How Emotions Influence Financial Decisions
Fear Can Sabotage Your Financial Decision Making
Fear can lead you to make some irrational and impulsive financial decisions. The “Fear Of Missing Out” otherwise known as FOMO, can cause you to jump into an opportunity simply because you feel everyone else is jumping in and you don’t want to be the one left with regret. The best financial decisions are often made after careful research and an evaluation of how they could fit into your portfolio and risk profile. Individuals often end up overspending on riskier investments than what they have the tolerance for and can also fall victim to scams, rug pulls, and get-rich-quick schemes. Fear can also cause an individual to pick ultra-conservative strategies and to sell out of positions as soon as the market downturns.
Greed Can Be A Blessing Or A Curse
While greed can push someone to take some financial risks, it also comes with the desire and overconfidence to earn fast money which can cause poor decision making resulting in losses. Furthermore, after such losses, individuals can engage in what’s often referred to as “revenge trading” attempts to regain such losses by engaging in taking part in even riskier investments without much thought to earn their money back.
Happiness Can Lead To Impulsiveness
Happiness and feelings of abundance can cause individuals to neglect budgets and long-term planning, in favor of spending and indulgence. Coming into unexpected large sums of money such as through an inheritance can lead individuals to throw all sense of financial planning out the window especially if they’ve never had that much money in their hands before. They might delay working with a financial professional to help manage the money or dramatically increase spending. Once they’ve realized some of the consequences of such actions it is usually too late.
CNN Business has created the Fear & Greed Index a tool that assesses whether stock prices accurately reflect their worth by considering how emotions impact investor willingness to invest in stocks. This index operates on the premise that fear tends to push stock prices down whereas greed tends to drive stock values higher.
How Cognitive Biases Influence Financial Decisions
Cognitive biases are mental shortcuts that the brain uses to process information quickly. They can often lead to systematic deviations from rational judgment. In the realm of finance, several cognitive biases come into play:
Confirmation Bias
Confirmation bias leads us to seek information that confirms our pre-existing beliefs. In finance, this can lead to a dangerous tendency to ignore conflicting evidence. If you believe a particular investment is solid, you might only seek information that supports that belief even if there is some data sources exist to encourage the investor to practice caution.
Overconfidence Bias
Overconfidence bias causes individuals to overestimate their abilities and knowledge. In the financial world, this can lead to excessive risk-taking and a belief that you can outperform the market consistently. This often results in losses.
Anchoring Bias
Anchoring bias occurs when we rely too heavily on the first piece of information encountered when making decisions. Investing it can cause investors to fixate on the initial price they paid for a stock which can lead to suboptimal decisions such as not selling a losing investment when it’s clear the situation has changed.
Loss Aversion Bias
Loss aversion can lead people to strongly prefer avoiding losses or acquiring equivalent gains. This can result in poor financial choices, such as holding onto losing investments for too long out of fear of recognizing a loss.
Imagine you’ve taken a position in a stock that you’ve held for many years and it has consistently underperformed, putting a strain on your portfolio. Due to anchoring bias, you fixate on the initial purchase price despite a negative forecast. Loss aversion bias makes you fear realizing a loss which can result in larger losses over time.
Strategies To Overcome Emotional And Cognitive Biases
Develop A Financial Plan
Having a clear financial strategy for your portfolio as well as a risk tolerance and allocations for risks is key to managing your finances successfully. Creating a plan can prevent you from risking too much money at one time and blowing up your portfolio.
Get Professional Advice
Consult with financial professionals that can give you an objective perspective on any investment decision. Professionals can help you make rational decisions.
Get Educated
Even though it’s great to have a financial professional to help you with managing your money, no one will ever care more about your money than yourself. The best financial decision you will ever make is to educate yourself on investing and managing your own money. Usually, the more educated and experienced one is in managing a portfolio, the better financial decisions they make. When evaluating whether to invest in an opportunity make sure you evaluate the pros and cons. Every single investment has pros and cons.
Manage Your Emotions
Practice mindfulness and self-awareness. Recognize your emotional triggers and take steps to control impulsive behavior regarding your finances.
Emotions and cognitive biases are an inherent part of human psychology and can significantly affect financial decision-making. By understanding that these biases exist you can work to counter their influence which will result in making better choices regarding your finances. Remember, the path to financial success begins with mastering your mind’s natural tendencies and biases. With diligence and self-awareness, you can navigate the world of finance with greater confidence and success. CM.
