Our financial decisions can greatly impact our quality of life. Whether it’s buying a car or investing in the stock market, emotions can cloud our judgment and lead to irrational decisions. Therefore, understanding how emotions affect our financial decisions is essential for achieving financial stability and security.
In this article, we will explore the link between emotions and financial decision-making, and look at some common emotional biases that can impact our financial choices. We’ll also offer strategies for overcoming these biases and making more informed financial decisions.
The link between emotions and financial decisions
Emotions play a critical role in our financial decision-making processes. In fact, numerous studies have shown that emotions are often the primary driving force behind our financial decisions, rather than rational analysis or careful planning. It’s broadly believed that emotions are the basis for 80% of the decisions we make in a day. So what’s the science behind this?
The role of the brain in processing emotions and decisions
Before we can fully understand how our emotions affect our financial decisions, let’s take a quick look at how the brain works.
Research has shown that areas of the brain such as the amygdala and insula are particularly important in processing emotions related to money. The amygdala detects potential threats and triggers fear or anxiety responses. Meanwhile, the insula processes emotional experiences and can be activated in response to the emotions associated with gains or losses.
Hormones such as cortisol and adrenaline can also affect our perception of risk and reward and influence our financial decision-making. By understanding how emotions impact financial decisions through the brain’s processing, we can become more aware of our emotional biases. This then allows us to take steps to make more informed financial choices.
The impact of emotions on financial behavior
Emotions can have a profound impact on our financial behaviour, influencing everything from our spending habits to our investment decisions. For example, when we are feeling anxious or stressed, we may be more likely to make impulsive purchases or engage in other forms of emotional spending as a way to cope with our emotions. Similarly, when we are feeling confident or optimistic, we may be more likely to take on greater financial risk or make bold investment decisions.
Examples of how emotions can influence financial decisions
There are numerous examples of how emotions can influence financial decisions, both on a personal and a societal level. For example:
- In the wake of the 2008 financial crisis, many investors pulled their money out of the stock market in a panic, even though this may have been the worst possible time to sell.
- People may be more likely to overspend on credit cards when they are feeling stressed or overwhelmed, as a way to feel better in the short term.
- When people are feeling optimistic about the economy, they may be more likely to take on risky investments, even if they don’t fully understand the potential risks involved. The 2021 crypto craze is a great example of this.
These examples demonstrate how emotions can override our rational decision-making processes. These also highlight the importance of understanding and managing our emotions when it comes to making financial decisions.
Emotional biases in financial decision-making
Emotional biases refer to the unconscious influences that emotions can have on decision-making. When it comes to financial decisions, these biases can lead to irrational and impulsive choices, which can have negative consequences on an individual’s financial wellbeing. There are several common emotional biases that can impact our financial decision-making. These include:
1. Loss aversion
One common emotional bias in financial decision-making is loss aversion. This is the tendency for people to feel the pain of a loss more strongly than the pleasure of a gain. For example, someone may be more upset about losing £100 than they would be happy about winning £100. This bias can lead people to hold onto losing investments longer than they should, in the hopes of recouping their losses, even when the evidence suggests that they should cut their losses and move on.
2. Confirmation bias
Another bias is confirmation bias, which is the tendency to seek out information that confirms our existing beliefs and opinions while ignoring information that contradicts them. Confirmation bias can impact our financial decisions in many areas of life. For example, if you believe that renting is a better financial choice than owning a home, you may only seek out information that supports that belief and ignore any evidence to the contrary.
3. Anchoring bias
Anchoring bias is another common bias that affects financial decisions. This is the tendency for people to rely too heavily on the first piece of information they receive when making a decision, even if it is irrelevant or unimportant. For instance, you may be willing to pay more for a product simply because it was the first one you saw, even if other products are available at a lower price.
4. Overconfidence bias
Overconfidence bias makes people overestimate their abilities and the accuracy of their predictions. This can lead to excessive risk-taking and poor decision-making. For example, an investor may believe they have a special insight into a particular market or industry and make large, risky investments based on this belief, even if the evidence suggests otherwise.
5. Ability bias
Finally, availability bias is the tendency to overestimate the likelihood of events that are easily recalled or available in memory. For instance, someone may be more likely to believe that a particular investment is a good idea because they have heard a lot of positive news about it recently, even if this news is not representative of the long-term prospects for the investment.
How to overcome emotional biases in financial decision-making?
Overcoming emotional biases in financial decision-making requires a combination of self-awareness, planning, and discipline. While it can be challenging to overcome these biases, there are several strategies that you can use to make more rational and informed choices.
Strategies to avoid emotional money decisions
- Awareness and mindfulness: Becoming aware of your emotions and how they may be influencing your financial decisions is the first step in overcoming emotional biases. Mindfulness practices such as meditation or journaling can help you become more attuned to your thoughts and feelings. By being mindful, you can recognise when emotions are influencing your choices, and make more rational decisions. This is also related to hedonic adaptation; being mindful of your emotional state can help you avoid falling into the trap of constantly seeking more material possessions to attain happiness.
- Creating and sticking to a financial plan: Having a clear financial plan can help you avoid impulse buying and other impulsive decisions based on emotions. By setting specific financial goals and strategies for achieving them, you can focus on the long term and avoid making decisions based on emotional reactions.
- Seeking advice from a trusted financial professional: A financial advisor or coach can provide you with an objective perspective and help you make more informed decisions. They can help you manage your emotions and develop a sound financial strategy. Seeking advice from a professional can also help to avoid distinction bias, as it provides an external source of input that can help to avoid excessive focus on one particular financial goal.
- Delaying gratification and avoiding impulsive decisions: Emotional biases can lead to impulsive decisions, such as making a large purchase or selling an investment based on short-term fluctuations. By taking the time to consider the long-term implications of a decision, you can avoid making rash choices based on emotions.
- Diversifying investments and minimising risk: Emotional biases can lead to overconfidence and excessive risk-taking, which can result in significant losses. By diversifying your investments and minimising risk, you can reduce the impact of emotional biases and protect your financial wellbeing.
Conclusion: How emotions affect financial decisions
Emotions can play a significant role in making financial decisions. You may make decisions based on your emotional states, such as fear, greed, or excitement, rather than on logic and analysis. This can lead to impulsive and irrational money decisions that can have long-term negative consequences.
Examples of emotional financial decisions include buying a high-risk investment based on a friend’s recommendation, selling stocks in a panic during a market downturn, or overspending on luxury goods to feel better about oneself. However, by becoming aware of emotional biases, creating a financial plan, seeking advice, and avoiding impulsive decisions, you can make more rational and informed financial choices and improve your financial wellbeing.