Maria Inês Padrão
Financial Markets
Raquel Dias
Financial Markets
When it comes to investing, few people reflect on the psychology behind this topic, as it has been taught only from a scientific perspective. In fact, it’s not often that we ask ourselves, “How do my beliefs affect my financial decisions?” or “How will the reality of the market I witnessed in my youth unconsciously affect my choices?” or even “What role do my emotions play when investing?” But the truth is that, since we are beings endowed with cognitive and emotional facets, our every decision cannot fail to reflect these same facets. It is then up to us to make use of our cognitive capacity and try to understand, perceive, and have a sense of how the emotional part influences us and know the methods to reverse this uncontrollable tendency to a more manageable and conscious reality. This is the theme that this article will be focused on: The influence of emotions on financial decisions.
Money and emotions: why do we invest?
“Controlling your time is the highest dividend money pays.”
-“The psychology of money”, Morgan Housel
It becomes easier to understand this complex confrontation between rational vs. emotional in investing when we have the basic relationship: money vs. emotions.
Every human tries to be happy, which is the key to a better life. It is complicated to restrict happiness to a single factor, as people are conditioned by many of them. However, “there’s a common denominator in happiness – a universal fuel of joy- it’s that people want to control their lives” (“The Psychology of Money” by Morgan Housel). Thus, it’s not difficult to understand that, since money is the key to having more control over our lives, people want to become rich, expecting to become happier. In fact, it is money that gives us a greater margin of decision, considering the limited time.
The influence of psychology before investing
“The reality you live in affects what you think about the opportunities that are presented to you.”
– Morgan Housel
Theoretically, it is known that people should invest based on their goals and the macroeconomic conjecture, However, that’s not what people do. We all make decisions based on our own unique experiences, what seems to make sense to us in a given moment. A quick and simple example is that a person who grew up in a period of high inflation (born in 1960) is likely to invest less money in bonds than those who grew up with inflation at lower levels (born in 1990).
As seen before, the entire context in which we insert ourselves and grow influences our actions. As such, the reality experienced also influences the beliefs that we develop. In fact, our view of money is shaped by the beliefs we acquire. The role of financial education as a tool to combat limiting beliefs is relevant, as it allows us to better understand the financial reality and deprogram these preconceived limitations.
Time to invest:
“The same characteristic that makes us human is the same one that subtly and undoubtedly influences everything we do, including our decisions.”
Inês & Raquel
The world of finance, in which the stock market stands out, is based on very sharp and diversified graphics, full of ups and downs every second. All of these “ups and downs” constantly stimulate the frenzy and anxiety that settles in the head of investors, whether they are professionals or not. The truth is that psychology is based on much more than professionalism and knowledge, going beyond what any human being can express or explain. That is why we often witness completely unexpected drops in an asset and immediately see its rapid recovery. The way each person deals with emotions in their decisions varies deeply from individual to individual. Some people are more nervous, more anxious, more impatient than others. But how related are emotions to financial decisions? This relation is deeply marked, since it is not uncommon for people to seek information that is in line with their pre-existing beliefs, as a way of validating it (confirmation bias). This can lead to a distorted view of financial options and hinder objective decision-making. Let’s imagine this situation: someone hears that a stock is currently trading at $100 and anchors their decision-making around this price, considering any price above or below it as overvalued or undervalued, respectively. This translates into the well-known anchoring bias, which occurs when individuals rely heavily on the initial piece of information they receive when making subsequent financial choices. Also, when individuals rely on easily accessible information rather than considering a broader range of options we have availability bias, which can lead to overlooking important financial opportunities or risks. Also, very noticeable is the loss aversion bias referring to the tendency to prefer avoiding losses over acquiring gains, which can lead individuals to make irrational financial decisions, such as holding onto losing investments for too long or selling winners too early. Furthermore, the framing effect shows that the way information is presented can influence decision-making. It is present, for example, when highlighting the potential gains of a financial opportunity is more persuasive than focusing on the potential risks.
Finally, we also witness constant dissatisfaction on the part of the investors, which is often based on excessive social comparison and the feeling of constantly missing out on opportunities.
So, how can we handle it?
Certainly, it is possible to mitigate the most spontaneous and momentary emotions with some financial education. In other words, everyone interested in investing must seek to obtain as much information as possible and, specifically, reliable information. Furthermore, each investor must understand their areas of interest, so that this search for information is more targeted and correct. However, it is worth highlighting the importance of the past, but also the macroeconomic conjuncture that surrounds each period.
However, the investor cannot be guided only by the historical past, since investors do not act only according to logic. In fact, due to this division between rational and emotional, it is impossible to consistently and accurately predict the actions of investors and, consequently, predict the behavior of the market.
Conclusion:
No matter how rational and strategic the task may seem, the simple fact that we are endowed with emotions means that the task is no longer guided solely and exclusively by cognitive factors, which can sometimes lead us to make decisions that are inappropriate for the situation. Consequently, it is crucial to be aware of the strong connection between these two sides and seek ways to avoid misjudging a situation because of emotional factors.
Sources
- Linkedin: https://www.linkedin.com/pulse/psychology-personal-finance-how-cognitive-biases-shape-dustin-whatley-gni3e
- Morgan Housel. (2020). The psychology of Money. Harriman House Publishing