If you are reading this article, it is almost completely guaranteed that you are human. And if you are human and do not have a major cerebral deficit, you have emotions. Perhaps have is not a strong enough word; everything you do, and every decision you make, is controlled by your emotions. Even the strive to take a logical approach to life is an emotional desire. Despite this, and even with the knowledge that you can never fully leave your emotions behind, the best financial decisions are made when you are aware of your emotions, control them to a point, and compensate for the effect they might be having on your decision making.
Emotions in negotiations
In this Sunday’s Consumerism Commentary Podcast, one of our guests is Herb Cohen, a master negotiator who advised Presidents Jimmy Carter and Ronald Reagan on dealing with the Iranian Hostage Crisis. One of his suggestions, framed around negotiating a major purchase like a house, will be not to fall in love with the object.
If you want a good deal, you have to be willing to walk away. If you let your emotions control your decision, you are much more likely to pay more than you should. The salesperson — or anyone else with whom you negotiate — will know right away if your emotions are controlling your decisions and will use this fact to their advantage. Your emotions give your power away.
Emotions in debt
Many otherwise smart people find themselves in unmanageable debt as a result of their own decisions. Not everyone is in debt for this reason, but some who are have made decisions fueled by emotions, where “want” and “desire” were the operative words. When it comes to getting out of debt, you could take an emotional approach or try to put your emotions aside.
As humans are emotional creatures, I can see why some people would argue that an emotional approach to getting out of debt would be successful. And it just might be in the short term. But unless this example individual, in debt due to emotional spending and using emotional decisions to get out of debt, changes their mindset drastically once they are in better financial shape, there is a good chance their emotional decisions will lead them back to debt.
I like to tell people about the Debt Avalanche method of debt reduction because it takes a more mathematical approach to getting out of debt. This approach helps people get used to separating emotions from financial decisions as much as possible. On the other hand, the Debt Snowball method relies on emotions — the same emotions that might have allowed us to find ourselves in trouble and might cause us to falter again. The Debt Avalanche does have emotional components, but it does steer us away from using emotions to guide actions.
Emotions in investing
The only way to make money in investing is to “buy low, sell high,” but this is the exact opposite of what actual trading behavior looks like. Most investors decide to buy after a stock or other investment has shown a confidence-inspiring pattern of price increases. They also decide to sell when the price has declined; if everyone else is selling, causing the price to go down, they must know something that we don’t know. We lose confidence in the investment, and we sell. “Buy low, sell high” is a mantra that all investors know, so why do we ignore this in practice?
The answer is our emotions. Rather that making decisions based on an investment’s underlying value and expectations for the future, we are affected by the media and the stock market. News and price movement inspire fear or excitement, and it takes these emotions to encourage someone to resist inertia and decide to buy or sell.
We can’t fully separate emotions from our ability to make decisions. However, just by being aware of the effect they have can help mitigate the bad choices. How do you deal with your emotions when making financial decisions?
Updated July 8, 2010 and originally published September 25, 2009. If you enjoyed this article, subscribe to the RSS feed or receive daily emails. Follow @flexo on Twitter and visit our Facebook page for more updates.