When it comes to financial decisions, emotions are our Achilles’ heel. Emotions like fear and greed affect our every financial choice and they are often difficult to control. Panic-selling stocks or impulsive buying altcoins are rarely purely logical, and more often than not emotions override reason, leading to costly mistakes. Some statistics claim more than 50% of investors admit that emotions influence their decisions, which is a pretty high number. The solution? Understand emotional triggers, build safeguards = better financial health. Let’s find out how.
Neuroscientific evidence for money and emotion
During stress, your amygdala and prefrontal cortex are in a fierce battle. The amygdala governs emotions while the prefrontal cortex accounts for logic. As a result, it becomes difficult to manage emotions and make objective and cold decisions. In fact, the emotions are so challenging that there is a whole indicator developed to address them in financial markets. The fear and greed index, which was developed by CNN, enables investors to gauge market sentiment and see whether markets are in fear or greed mode. The existence of such an indicator directly indicates that human emotions should not be ignored in investing and other financial decisions. Fear and greed responses were designed for survival, not for modern finance. The neurochemical triggers behind these emotions are also different. Dopamine affects greed as it is a reward-seeking hormone, while cortisol is fear-driven decisions.
Top 5 Offender Emotions in Finance
The top 5 emotions affecting financial markets and financial decisions are:
- Fear – Panic selling causes major market crashes and crises.
- Greed – Chasing hot stocks, FOMO-driven investing resulting in losses.
- Overconfidence – Typically results in excessive risk-taking. Ignore diversification and risk management.
- Regret aversion – Holding losing stocks too long is another common phenomenon among everyday investors.
- Social pressure – Lifestyle inflation to keep up with peers.
These emotions are what make proper financial decisions so hard, and this is why most traders and investors tend to lose money.
Common Cognitive Biases
Top cognitive biases stemming from our mind include loss aversion, anchoring, confirmation bias, and present bias. The loss aversion is the payoff losses and joy of gains, which forces investors to sell winners too early. This is more common than you might think and also one of the main reasons why traders fail. Anchoring occurs when you over-rely on initial info, like fixating on a stock’s all-time high, thinking it can not go even higher. Confirmation bias is when one seeks information that justifies their emotional choices. This one is really dangerous and can create a whole set of reasons why various incorrect decisions are correct. Present bias is when prioritizing immediate rewards over long-term gains, which often leads to overspending and less planning for long-term investments.
Real-life consequences – When emotions cost you
Emotional traders underperform the market. This is because emotions often lead to incorrect and impulsive decisions, which damages the portfolio. Beginner investors who are mainly governed by emotions tend to buy tops and sell bottoms. They are under FOMO which is a fear of missing out, forcing them to make bad investment decisions. However, this phenomenon extends beyond just investment and in real-life many people tend to impulse purchase which drives credit card debts. Procrastination often leads to under-saving, which is caused by the present bias.
Strategies for emotion-proof financial decisions
To break the cycle, there has been a decisive strategy developed. Emotional intelligence is an art of making financial decisions and other strategic decisions under stress without letting your emotions affect your decisions. Probably the most important skill, emotional intelligence is not taught in universities and schools, which is very unfortunate as it is the main skill to manage life better in every way. Here are some key methods to ensure emotions no longer have power over your financial decisions:
- Pause protocols– Impose a 24-hour cooling-off policy for big decisions to ensure you make decisions without emotional biases.
- Automation – Automate monthly payments for your investment accounts to ensure no emotions are involved.
- Plan emergency rules – If the market drops by a certain percent, rebalance, do not sell right away to avoid panic selling.
- Diversification – Spread capital across different assets so that fear and greed triggers are eliminated. If one asset underperforms, others will balance it with their performance.
- Reframing language – How you compose sentences in your mind matters – replace I lost $1K with I own the same amount of shares.
Overall, emotions like fear and greed and cognitive biases lead to worse financial decisions as they were developed to protect us from threats, most of which no longer exist for us in the modern world. To defeat these biases and bad emotions, you need to first know about their existence and their influence over decisions, and then develop safeguards by making financial decisions objective.
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