Understanding Behavioral Finance: How Emotions Affect Your Investments

Investors' emotions and behaviors affect their returns far more than they realize. An entire study and an untold amount of money have been spent trying to understand people and their relationship with money.

Our relationship – mostly broken relationship – with money spans known human history. Money makes us FEEL a certain way and it is usually strained at best. Solomon, Paul, and others wrote this financial relationship in the Bible. Other great minds in history have attempted to give their generation financial advice probably because they saw the pain that bad financial behavior caused.

So, let’s focus on the study of behavioral finance and what it may teach us about ourselves. What is behavioral finance, and how does it differ from traditional finance? Books have been written to explain this answer.

But in short:

Efficient Market Hypothesis and Modern Portfolio

In traditional finance, the models and theories that arise from traditional studies assume rational behavior and efficient markets, relying on models like the Efficient Market Hypothesis and Modern Portfolio theory. Understandably, theories need baselines to begin testing. However, markets are neither completely efficient nor inefficient, and people are certainly not rational. This leads us to behavioral finance.

Behavioral Finance introduces the psychological factors that explain why people often act irrationally, make mistakes, and why markets deviate from efficiency. These and other ideas help explain phenomena like overreactions to news, stock market bubbles, and why people trade too much or too little.

In that case, what are the most common emotional biases that affect investors?

Fear and greed

Fear and greed – many articles, papers, and books give a far broader range of emotions than these two. But in my two decades, plus of experience, fear and greed drive many of our financial decisions.

Fear

Daniel Kahneman and Amos Tversky theorized that most people fear loss twice as much as they enjoy gain. (Prospect Theory 1979) Let that sink in – how does loss affect your financial decisions? If you flipped a coin five times in a row, calling heads and losing each time, what are the odds of you losing the next coin toss?

While your odds have not changed, how would you feel about those odds? Our fears either hold us back causing us to lose because we never risk, or we take outsized risks because we fear (or hate) loss so much that we will do anything to avoid it.

Greed

Also known as FOMO (fear of missing out) drives the other half of our unwise investing decisions. We all are guilty of comparing ourselves to others. Inevitably, we compare our “worst,” what we know about ourselves, to their “best,” what we see on the outside. When done in investing or any financial actions, people chase ideas they don’t understand without managing risk in any way. It eventually becomes a disastrous combination and could take years to unwind.

So, what can we do about these problems – what strategies can you use to mitigate the impact of emotions on your investments?

Humans Are Emotional

First, realize that you are emotional – all of us are emotional, so you are not alone.

Then learn how you are emotional, For example, I know that I fear loss more than I enjoy winning. I hate losing with such a passion that is left unchecked I will take any risk to not lose. I feel losing is a personal insult. Therefore, I have become a very rules-based investor plus I have people hold me accountable in my life. And I take an active approach to seeking gains and managing risk.

• So, what emotions tend to dominate your life?
• How do you manage those when making financial decisions?
• How does understanding behavioral finance help in creating a more effective investment strategy?

When you understand emotions in general, you can understand why people make the financial statements they make. Consider this, have you ever heard anyone talk about how much money they lost at a casino? No. When they lose money, they talk about how good the food was, the cool show they attended, or (unfortunately) how much they drank.

But when they win…they tell everyone! Have you ever considered that these same people invest in the stock market and carry the same behavior into public? They brag about their winnings and keep their mouth shut about losses. So, take what others say about their financial position with a little caution.

When you understand your emotions then you can make better financial decisions. Always consider, what is your goal? Your goals should drive your financial plans which determine your actions. When you understand your financial behavioral tendencies, you know how to recognize them when they start to cause you problems. You can then respond appropriately.