Average investors tends to think of themselves as highly logical, yet 80% of individual investors are more emotional than rational. Humans have very complex relationships with money, which evolves with the influences that enter our sphere, dispositions, biases, challenges, triumphs and internalized emotions when risks go right or wrong.
Financial psychology looks at the human mind and behaviors involved with investing, spending and saving decisions. The discipline draws from other areas, including cognitive, developmental, social and consumer psychology, as well as sociological concepts that focus on group behavior.
Professionals in this field develop and test hypotheses to formulate theories, methods and models for predicting human decisions and helping people improve their financial and investment choices. Financial advisors use these tools and factor in client psychology, which is the application of this knowledge in the context of the advisor-advisee relationship.
The online Master of Science program in Finance from University of Illinois Springfield will help financial advisors coach their clients to understand and manage the natural emotions and impulses that impact financial decision-making.
Emotions Can Steer Individuals Off Course
The primary emotions related to financial decision-making are fear, guilt, shame and envy. Awareness of the impact of these emotions is key to overriding their potentially adverse consequences.
Fear in personal finance and investing harms individuals in various ways, depending on psychological profiles and prior experiences. They may fear others’ envy if they make strong financial decisions or fear making a bad impression on friends and family if they falter. They may feel guilty if their decisions have negative consequences for others, such as investing a child’s college fund in a bear market. In personal finances, people may feel shame for not earning as much money as they would like or for spending too much money. Ultimately, shame is a fundamental emotional driver in investing because decisions gone awry often lead to financial decision-making anxiety and avoidance.
The Disposition Effect in Investing
The disposition effect explains a common and counterproductive aspect of the investor experience. The term, developed in a 1985 study by economists Hersh Shefrin and Meir Statman, describes a human tendency to sell winning investments too early without realizing most potential gains. It can also refer to holding losing investments, hoping to ride out a downturn for a recovery that either never occurs or comes with significant opportunity costs. From a tax standpoint, the disposition effect increases capital gains taxes because investors sell winners too soon. Personal financial advisors must understand this phenomenon in their work.
Influences and Biases
Humans have built-in biases, as well as influences that overwhelm rational and logical decision-making in personal finance and investing. Advisors who understand this human behavior can help their clients become aware of how the following concepts factor into their decisions:
Confirmation Bias: Investors tend to believe information that confirms their notions and disbelieve information that conflicts with how they already think, even if the information is faulty.
Experiential Bias: Otherwise known as recency bias, this concept refers to the powerful influence of personal history on investors, especially recent events. Many outcomes are possible, but these biases incline investors to expect results they have experienced recently or frequently more than outcomes they have not experienced as often.
Loss Aversion: Investors who have taken significant losses may be shell-shocked and approach future decisions with more caution about potential losses than eagerness to achieve potential gains. This risk-averse tendency can cause them to lose out on the best opportunities rather than balancing risk with reward in a diversified portfolio.
Overconfidence Bias: The opposite of loss aversion, overconfidence causes investors to believe too much in their abilities or prior achievements, causing them to take too much risk or fail to properly diversify.
Familiarity Bias: This bias is controversial because many investment advisors encourage investors to focus on companies they know and understand. This practice can lead to an imbalanced portfolio that leans too heavily toward domestic investments or investments in a particular industry.
How Can Financial Pros Help Investors?
Personal finance or investment advisors must approach their work with rationale and a level head, but they must understand that clients’ emotions, dispositions, experiences, influences and biases can lead to poor decision-making. A well-educated advisor who understands why clients sometimes do not use rational and logical thought processes can provide insights and guidance to improve their clients’ decision-making and outcomes.
Advisors can also scientifically measure characteristics they observe in their clients over time to accurately predict future decision-making and guide clients. Over the long run, this information can be more valuable than expertise on specific investment options, making the personal financial advisor with training in psychology an asset with compounding value to clients.