By John Spoto
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 is that conventional economic theory assumes that people make financial decisions based upon rational, rather than emotional, factors. However, in the real world, when faced with incomplete information and uncertainty, they often behave unpredictably and irrationally. Individuals in similar personal and financial situations 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 those emotions. It is not easy to ignore the euphoria when the stock market is soaring and everyone else (you think) is making a killing, or the panic when the market is plummeting, as it has done in the past couple of weeks, and your retirement savings and child’s college fund seem to be evaporating by the day.
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 that 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.
In other words, great investors do not confuse facts with feelings, and they understand that success is mostly about behaving rationally, not emotionally.
In the next couple of 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.
This article is for general information purposes only and is not intended to provide specific advice on individual financial, tax, or legal matters. Please consult the appropriate professional concerning your specific situation before making any decisions.
John Spoto is the founder of Sentry Financial Planning in Andover and Danvers. For more information, call 978-475-2533 or visit www.sentryfinancialplanning.com.