The human brain is incredibly complex and unique in its design and is responsible for giving each and every one of us our individuality. Our brain crafts our personality, thoughts, and feelings, but it can also alter the way we make decisions.
We are emotional creatures, and our emotions can sometimes get the better of us. They can make us irrational and impulsive. This leads to unconscious, thoughtless decision-making, like saying something you don’t mean in the heat of an argument.
But if you make reckless decisions with your finances, and the risks don’t pay off, the results could be bleak and long-lasting. Read on to find out how your psychology can impact your decision-making and your finances, and what you can do about it.
The pain of losing is twice as powerful as the pleasure of winning
There are a few ways that your emotions could affect your rationality and thought processes. For example, it’s psychologically proven that the pain of a loss is greater than the satisfaction of a win, no matter your circumstances.
Whether watching your local football team, playing a video game, or investing in the stock market, a loss will likely hurt more than a win will feel good.
This phenomenon, known as “loss aversion”, was first identified in Daniel Kahneman and Amos Tversky’s Journal of Risk and Uncertainty, in which they conducted studies showing that losses could be twice as psychologically powerful in their future impact than gains.
This could leave you more focused on the potential negatives of a situation, rather than the potential or even guaranteed positives.
The opposite can also be true, where you fail to consider the consequences due to overconfidence. Let’s say you have a good run with something: you win three hands of poker back-to-back, or you bet on the winning horse five races in a row.
A hot streak can boost your confidence and might make you take more risk, a decision you may well regret if you don’t stay calm and measured.
Additionally, decisions can be overwhelming and can lead to “choice overload”. The brain can easily be fatigued, and needing to make a lot of choices in a day can be tiring. The more choices you make, the less you think about them, and the worse the outcome may be.
Lastly, humans have a natural herd mentality. Evolutionarily, we are pack animals; we live in groups and often don’t like to be alone. The same could be said for the choices you make. If several people you know choose to do something, you want to feel included, and are more likely to do it too.
But can the way your brain works really affect your finances?
Loss aversion, overconfidence, choice overload – they can all affect your finances
The short answer is yes. Think about loss aversion, for example. If you’re more worried about the possible pain of a loss than the potential positive, you may make less risky decisions and not achieve the investment returns you were hoping for.
Alternatively, you may hold on to a stock that is clearly failing instead of selling early. By attempting to avoid the pain of a loss, you are instead letting the situation worsen.
Overconfidence can lead to the opposite, causing you to take taking unnecessary risks with your finances. Over-the-top bets after a lucky streak or throwing thousands on a high-risk investment after good returns are some examples that could come back to bite you.
Overconfidence could also lead to the “endowment effect” whereby you have more confidence in things you already own and hold them to a higher regard. This could cause you to double down on an investment that isn’t going well or, much like above, fail to sell a stock when it is failing.
Choice overload can also occur when you have too many options to choose from. In some circumstances, choice overload can lead to you avoiding the decision altogether, possibly missing out on good opportunities.
Plus, making too many choices in a day is likely to make you lazy. From what to wear, to what to eat for each meal, and who to delegate a task to at work, you make a lot of choices each day. Adding financial decisions to the mix makes you more likely to simply choose the quickest or easiest option.
This may not be the best investment strategy.
Lastly, a herd mentality can be detrimental if other people aren’t making the right decisions. If you follow the crowd but the crowd is wrong, you end up being wrong too. For example, investing in a popular stock, such as GameStop from early 2021, may not yield the returns you were expecting.
A herd mentality can also lead to the fear of missing out, which compels you to make rushed decisions. Even if there is no reason to believe that a stock is going to perform well, but there is a limited time to buy it at a certain price, you may choose to invest despite having no reason to.
Financial planning can help prevent your emotions taking control
When it comes to your finances, it’s always best to take a step back and tackle any problem with a level head. Rushing through and impulsively acting on financial decisions could be something you later regret.
Try saving important financial matters for the moments when you feel most productive and focused. It’s not worth making rushed decisions because you’re tired and want nothing more than to get it done.
The most effective way to ensure you don’t make impulsive, incorrect decisions with your money is to contact a financial planner. The help of a professional is invaluable, as they can act as a sounding board for your decisions, give you confidence in your choices, and help ensure you stay on track.
Get in touch
To contact a financial planner who will help you navigate your own psychology and ensure you make the correct decisions, please get in touch with us at Lightside Financial Planning.
Fancy a chat? Email email@example.com or call 0151 372 0161.
The value of your investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance. Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.