Behavioral Finance: A Commotion of Emotions

Behavioral finance is a relatively new but burgeoning subfield of behavioral economics, which tells us that people are not perfectly rational with their money. Not surprised? We aren’t either. Nothing is perfectly rational, even technology (since it’s built by people, after all).

With a topic as individual as personal finance, it’s only normal to let emotions play a role when making decisions. But how much of a role should your emotions play, and when should you reel them in? Studying behavioral finance, we learn that biases and heuristics (which are mental shortcuts we use to make or not make quick decisions) can influence our decisions. These mental shortcuts can become inaccurate judgments and beliefs, also known as biases. And, of course, biases and heuristics are influenced by our emotions. 

Recently, the word “recession” has been floating around. Ignoring a powerful statement about our economy isn’t easy and might have you concerned about the stock market. Sometimes the word “recession” can sound a lot like “sell now!” Although you might know it’s best to stay patient and disciplined, we understand it’s easier said than done.

In this article, we’ll provide insight into three concepts of behavioral finance you might be experiencing, tips for managing concerns, and ways you can find relief and have confidence in your financial future.

1. Recency Bias
Have you ever thought to yourself, “wow, it’s always raining over here,” after a week of rain showers, but the month previous was dry, and your grass was brown? If so, you’re certainly not alone. People usually find it easier to remember recent events than past events. During the month that your grass was brown, you might have even said something like, “it never rains here; my grass needs water!”

A more finance-related example is found in the recent downturn of our stock market and economy. During a downturn, it can be easy to think that stocks won’t stop going down and that you must sell, or else. However, just as your grass was brown and hope seemed lost until it rained again, the stock market isn’t much different. It might be helpful to look at the stock market’s history if you find yourself getting caught up in what’s happening now. Looking at the stock market’s history, we can be optimistic about the future and see the benefit of those who were patient.

2. Loss Aversion
Imagine you’ve just been gifted your favorite dessert by a friend. How did that make you feel? Now imagine when going to set it on the counter, you dropped it. The feelings you got from dropping it might have been stronger than when you first got it, and that’d be completely normal. People usually feel loss more than they do gain. We also see this with investing.

Sometimes, you might want to stay in cash or something less risky than stocks, especially during downturns, to save yourself from experiencing financial loss. If you’ve ever experienced this, it might be helpful to remember that financial risk is always present. You’d never reject a dessert out of fear you might drop it, even if it feels worse to lose what you just gained. Similarly, avoiding the stock market for fear your investments might lose value can leave you with a greater loss by missing out on potential rebounds in the stock market.

3. Herd Instinct
Fashion is an industry that works with trends. These trends are influenced by the environment, politics, religion, demographics, and much more. As time goes on and these factors change, so does fashion. But there isn’t an announcement that says what clothes should look like, so what makes people change? As with most trends, you might’ve heard people say, “it’s the new thing; everyone’s doing it!” Investments exhibit this as well.

When the market takes a downturn, as it has been, people get worried and start to sell their investments. Next thing you know, everyone seems to want to get out of the stock market. A sense of urgency can be created and make you feel like following what everyone seems to be doing. But it can be helpful to take a step back and look at your circumstances only. Everyone has a unique financial plan, and no two people are affected by the stock market the same. Reaching out to a trusted advisor can help you choose the optimal path for your unique financial plan.

When the market and economy start to perform poorly, you might see people discussing how important it is to stay invested, patient, and disciplined. Even if you know what you should do, we understand it is easier said than done. Hopefully, by learning about recency bias, loss aversion, and herd instinct, you’ve gathered insight into what you might be experiencing and how you can manage concerns. Always feel free to consult your trusted advisors, so we can help provide peace of mind for your finances.