Emotions trump smarts
Making good financial decisions can be difficult, even for very smart people. One reason is that most people make decisions based in large part on their own biases and the emotions they are experiencing at the time rather than analyzing the facts. In other words, their choices are based more on what they are feeling rather than what they know. However most decisions, especially financial ones based on emotions, often turn out to be the wrong ones.
The difference between theory and practice
Conventional financial theory assumes that people make financial decisions based upon rational rather than emotional factors. In many cases, however, this assumption doesn’t reflect the reality of the real world where things can get messy and people often behave unpredictably and irrationally. We see it in how people in otherwise similar personal and financial circumstances behave radically differently when it comes to spending, saving, and investing their money.
Since the 1990s the emerging field of behavioral finance has been applying 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 way people make decisions. The implications are important
because if we can better understand the role these factors play, we can learn to recognize and harness them, improving 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 fund and your son or daughter’s college fund is evaporating by the day.
The key to successful investing
What sets successful investors apart from everyone else 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 brilliant people who have been spectacular failures at investing. It is rather the ability to recognize and understand what their emotions are telling them and then although it may not feel good at the time, to either control them or use them to make a more informed and rational decision. The bottom line is that great investors don’t confuse facts with feelings and they understand that success is mostly about behaving rationally, not emotionally.
In the next several articles we will address some of the important principles of behavioral finance and discuss how you can apply them to help you become a better investor.