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Investor Psychology: Why We Fail to Make Good Financial Decisions

by Flexo on October 21, 2009

in People

Investors make better decisions when they separate emotions from the thought process, but it’s practically impossible to achieve the goal in perfection. Regardless of how hard one tries, emotions will always be present. The best an investor, or anyone who makes decisions about finances, can achieve is awareness of the ways psychology prevents optimal decision making.

I took Kiplinger’s new investor psychology quiz, which focuses on the ways investors’ brains work against us as we try to make solid investment decisions. I answered seven of the eight questions correctly. The quiz was a good reminder of the brain’s subtle ways of changing perception and understanding of a situation.

Here are some interesting aspects of psychology that hinder the best decision-making.

Recency effect

We tend to remember better events that happened most recently. While at the peak of a bubble, like we’ve seen in real estate and stocks, several years of increases hide the reality that bubbles burst when high prices are not supported with fundamental value. Likewise, if you are asked to review your experiences at a restaurant, even if you have visit that restaurant for decades, your most recent experience at that venue will have the most weight.

Here’s how this can damage you: In the midst of a recession, it seems like the stock market keeps getting lower. All we see is bad news like financial scandals and corruption. We forget that over the long term, the stock market has been the best way to grow your money. So we abandon the stock market and miss out on those gains when the economy rebounds.

Confirmation bias

There are certain things we want to believe. Several years ago, a friend told me that “real estate always goes up.” There’s the recency effect again. Also, to believe that any investment can’t fail, we must ignore information that does not fit in with that philosophy. We seek out the studies or opinions that match our own as we look for confirmation.

Here’s how this can damage you: If you are looking to buy a house, it would be smart to look for reasons that the purchase will be financially sound over the long term. You will cite the usual positive aspects of home purchasing, including the fact that it’s an asset likely to appreciate and you receive a small tax break on mortgage interest, but you’ll likely ignore the fact that you’re likely to move out of the house before buying gains its advantage over renting.

Losing money is painful

The brain reacts to losing money the same way it reacts to pain. As pain is something we are built to avoid, we also try to avoid any potential for losing money. On the surface, this sounds like it would be a good thing, producing decisions that are more likely to side with gaining rather than losing. What really happens is that if we are presented with a situation where we have an even chance of winning $150 or losing $100, we won’t take the chance.

Here’s how this can damage you: The fear of losing money and experiencing the associated pain will keep us from taking risks. For people invested in the stock market, the pain experienced when reading those quarterly statements with negative returns causes many to sell at the wrong moment. They’ll miss out on the market’s rebound. While the stock market has a great track record over long periods of time, if you’re only invested when the market is decreasing, your performance will never match the stock market.

Want more? Here’s a list of cognitive biases. Just about everything pertains to financial decisions in some manner.

Photo credit: Martin Pettitt

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Keep Emotions Separate From Financial Decisions

by Flexo on September 25, 2009

in Personal Finance

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?

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Emotions and Money: When to Keep Them Separated

by Flexo on October 20, 2008

in People

Human beings aren’t logical, and it doesn’t take a scientist from Vulcan to prove that fact. A corollary to this statement is that human beings do not make logical decisions when it comes to their personal finances. Consider some things that could happen if people thought about the financial consequences of every choice:

  • People would save a greater portion of their income, creating havoc for retailers.
  • Consumers would buy only what they need, destroying the market for luxury items.
  • The Joneses wouldn’t have anyone following them and might die of loneliness.
  • Families would not have children, savings hundreds of thousands of dollars.
  • Environmentally conscious options more expensive than the alternatives will not be pursued, causing the planet to eventually perish (sooner than otherwise).

Thankfully, people do not base all decisions on financial rationality alone, and thus our economy, species and planet continue to survive and thrive, although the economy has been taking a beating recently. Emotions and money are linked, but there are some instances when an individual will be better off by separating the two as much as possible.

Investing during a highly-volatile market. Your asset allocation should relate to your time horizon, not react to the current hype in the news. If you had decided that you could withstand short-term market plunges with the goal of a long-term gain through stock market investing, don’t let fear and panic dictate changes when the market dives.

Evaluating products and services. Advertising and marketing are important. This is how a company gets information about its products and services to the public. Every year, the advertising industry advances further, using scientific research that explains how emotions are tied to everyday decision making.

The commercials that you see on television are developed specifically to influence shopping decisions. Even non-profit organizations use your emotions to their advantage; how many times do you see commercials for charities using videos of children who appear to be malnourished and obviously in need of help?

Chances are we’re being marketed to in ways we are unaware. Product placement in television programs in passé, now even presidential candidates are advertising in video games. This is a game the consumer can usually not win. Thankfully there are resources that help us see through the marketing noise, such as Consumer Reports, Charity Navigator, and GuideStar.

Getting out of debt. If you’re in debt, there’s a chance that your emotions led you there. While it’s true that many people are in insurmountable debt due to circumstances beyond control like a medical emergency or a natural disaster, a good portion of people are in debt because they enjoy spending money without thinking about or understanding the financial circumstances.

Some authors and radio show hosts want to have these people get out of credit card debt by playing to their emotions, the cause of debt in the first place. This only solves a short-term symptom, the debt, rather tan the underlying problem, spending decisions based on emotion. It is likely that someone who lets their emotions control their spending as well as their path to reduce their debt will fall back into debt later on. This is why I suggest the “Debt Avalanche” method of getting out of debt. It helps separate emotions from your decisions, a pattern than will help keep you out of debt once you reach that point.

Purchasing a house. I wrote recently about ten tips for buying a house in any market. Ron from The Wisdom Journal wrote in with this comment: “One thing I would add, and it’s very difficult to do, but try to take emotion out of the buying process and especially the negotiation process. Emotions can cause you to pay too much and make a decision that you’ll later regret.”

You want to live in a house that you will like, preferably for a long time. That has to be a part of your decision making process. If you plan in spending a lot of time with this major purchase, it should very well be with a product that makes you happy. The danger comes in the belief that that particular house may be the only one for you. You might fall in love at first sight with your soul mate, but a house is just a house. Don’t get so caught up that you feel you must have the house at any cost and be willing to pay any price to get it.

A better understanding of how your emotions are involved with money is a key to overcoming the influence for certain important decisions as much as possible. Here are a few articles that could help.

When It Comes to Money, Emotions Run High, Psychology Today. “Despite our best efforts, economic decisions can be influenced by emotion. Researchers offer a neurological explanation: The part of the brain that controls negative thinking can often override logical thought…”

The Psychology of Money (series), PsyBlog. “Until recently social scientists didn’t know much about the psychology of money. That has changed with an explosion of fascinating findings on how it affects our emotions, our personalities, our sexual behaviour, our risk-taking and society at large…”

How to Treat a “Money Disorder”, Sarah Kershaw, The New York Times. “Among the problem financial behaviors identified by psychologists in recent years are: overspending, underspending (aka Depression mentality), serial borrowing, financial infidelity (“cheating” on a spouse by spending and lying about it), workaholism, financial incest (lording money over relatives to control them), financial enabling (throwing large sums at, say, adult children who then are not motivated to support themselves), hoarding, and plenty of guilt and shame around poverty and wealth…”

Emotions are intricately linked with the financial decision making process, and are in fact necessary to make the correct choices in many situations. Even a small effort to put feelings aside in certain circumstances and think rationally could go a long way towards improving the quality of those decisions.

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