Emotions trump smarts. Making good financial decisions can be difficult, even for smart people. One reason is that most people make decisions based in large part on their biases and the emotions they are experiencing at the time rather than a thorough review of the facts. In other words, their choices hinge more on what they feel rather than what they know. While many emotional or intuitive decisions turn out to be correct, others, particularly financial ones, turn out to be wrong.
The difference between theory and practice
Conventional economic theory assumes that people make financial decisions based upon rational rather than emotional factors. However, in the real world when we are faced with incomplete information and uncertainty, we often behave unpredictably and irrationally. We see it in how individuals with similar personal and financial circumstances behave very differently when deciding how to spend, save and invest their money.
Since the 1990s the field of behavioral finance has applied knowledge developed in the areas of psychology and neuroscience, as well as finance and economics to more fully understand how people approach financial decision-making. This includes how biases and emotions can distort reasoning and influence the choices that we make. The implications are important because if we can better understand the role these factors play, we can learn to recognize and harness them to improve the quality of our decisions.
Humans are emotional beings, so don’t underestimate the difficulty of controlling your emotions. It’s not easy to ignore the euphoria when the markets are soaring and everyone else (you think) is making a killing, or the panic when the market is plummeting and your retirement savings and child’s college fund is evaporating by the day.
The key to successful investing
What distinguishes successful investors from others is not the ability to predict the direction of the markets because history has shown that no one can do this consistently. Nor is it financial genius, because the road to financial success is littered with stories of brilliant people who have been spectacular failures at investing. Rather it is the ability to acknowledge the powerful negative impact that emotions have on the decision-making process and develop a plan in advance to resist the emotional pull when making important financial decisions.