In a perfect world, logic would always guide our financial decisions. Emotions wouldn't come into play. However, we don't live in a perfect world. . . far from it.
That means our emotions impact our financial choices more than we realize.1 Shockingly as much as 95% of our purchase choices are made subconsciously, driven by our emotions - as little as 5% made with logic.2
When faced with uncertainty, fear and instinct can take over. Your brain will want to react quickly to help you avoid any anticipated pain from possible loss.4
However, operating by instinct alone can make things worse. Emotional reactions can result in poor decisions, which bring about the very thing we were trying to avoid to start with.5
Today we're going to discuss some strategies to use to avoid emotional decisions when investing.
1. Avoid the trap of over-confidence.
Research shows that the more experience you have as an investor, the more overconfident you tend to become.6
Solution: Stay realistic and grounded. Use a defined investing strategy. Get advice before making big decisions.
2. Put your emotions in the back seat.
The pain of losses can actually be more intense than the satisfaction from gains. Economists call that "loss aversion."7 Anxiety and uncertainty can lead to irrational choices that actually work against our big-picture financial goals.
Solution: Don't give in to fear or panic. Focus on logic and rely on your relationship with a trusted professional for guidance.
3. Frame performance in a more meaningful way.
Framing is everything when it comes to evaluating performance. That's because the way information and events are presented to us can sway our perception and influence our decisions.8
Solution: Look beyond short-term outcomes when framing performance. Be aware of how news is presented. Think about your longer-term goals and the progress you are making toward them, even when short-term corrections slow your progress.
4. Neutralize your recency bias.
Recent events usually influence you more than those in the distant past. The human brain tends to remember recent events more clearly and considers them more heavily when making decisions. Your brain can mislead you by expecting more of what you've seen already, and that can lead to overconfidence and emotional decisions.9
Solution: Resist this tendency by remembering the market is constantly changing. Over the long term, bear markets recover. And, so far, no bull market has lasted forever.
5. Consider multiple perspectives.
With decision making, it's natural to focus on one aspect or piece of information as a starting point. This tendency, known as anchor bias, can greatly influence our final choices and cause tunnel vision. It can lead you to fixate on a single data point - such as an investment's price - while ignoring other key information.
Solution: Seek out more information. Think critically about an issue from multiple perspectives. Consider future potential as well as the possibility for loss.
6. Slow down and take to time think.
Many people tend to make snap decisions. And, in stressful times, we're even more likely to respond impulsively. The issue with this is that gut decisions are usually based on instinct, habits, and emotions - rather than logic and facts. When we're operating in "gut mode", it can be harder to make goal-focused decisions.10
Solution: Take your time when making financial decisions. Let your brain shift into analytical mode. Allowing your emotions to cool down will typically allow you to consider a variety of alternatives.11
We can't foresee or control downturns or upswings. We can only control our mindset, our emotions, and our financial choices.
As financial professionals, one of our most important jobs is to help you become a smarter, more capable investor. That involves using psychology and behavioral finance to help you learn more about how your brain works and how to improve your financial decision making process.
Are you making some important financial decisions? It's our privilege to partner with our clients in the their financial decision making processes. Give us a call today to discuss more.
1. https://scholar.harvard.edu/files/jenniferlerner/files/emotion-and-decision-making.pdf?m=1450899163
2. https://hbswk.hbs.edu/item/the-subconscious-mind-of-the-consumer-and-how-to-reach-it
3. https://www.psychologytoday.com/us/blog/the-divided-mind/201207/logic-and-emotion
4. https://www.psychologytoday.com/us/blog/science-choice/201803/what-is-loss-aversion
5. https://www.cmu.edu/dietrich/sds/docs/loewenstein/RoleEmotionEconBehav.pdf
6. https://www.sciencedirect.com/science/article/pii/S0970389615000944
7. https://www.scientificamerican.com/article/what-is-loss-aversion/
8.https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/framing-bias/
9.https://www.sciencedaily.com/terms/anchoring.htm'
10. https://www.sciencedirect.com/science/article/pii/S2352289515300187
11. https://www.scientificamerican.com/podcast/episode/making-a-decision-take-your-time-10-04-17/
