The Psychology of Money – Emotions and Decision-Making

Money can be an inexact science; unlike math-related fields, its outcomes often depend on personal history, unique perspectives, ego and marketing considerations.

Morgan Housel’s award-winning book explores these themes through 19 short stories that illuminate people and their financial decisions, providing readers with a better understanding of how money impacts life. These tales help readers recognize their own money mindset as well as gain strategies on making sense of such an essential aspect of living.

Emotions and Decision-Making

Investment, personal finance and wealth-building decisions rarely if ever occur within an Excel spreadsheet. Instead, most often they occur around dinner tables, meetings or buses where personal history, ego, pride, marketing incentives or unusual incentives all play into decisions that can have profound ramifications on one’s future finances.

Visceral emotions have an overwhelming influence on human decision-making behavior, often overruling rational thought and cognitive processing. Fear, anger and anxiety are powerful visceral emotions which can drive individuals away from acting in their best interest – for instance selling stocks during market downturns due to fear of further losses.

Be mindful of your emotional triggers so you can avoid making costly errors and make more rational choices. Explore behavioral finance and discover strategies for balancing emotion with logic when making investment decisions.

Emotions and Finances

Financial decisions are often driven by emotions that influence them in ways other than logic. Understanding these emotions and what they indicate can help you make wiser financial choices.

Behavioral finance is an area of study that marries insights from psychology, sociology and biology with conventional finance concepts like risk, return and investment. It seeks to explain why people sometimes make irrational decisions that conflict with conventional economic theories that assume everyone is rational; in addition, behavioral finance offers methods of avoiding cognitive biases such as anchoring (setting spending levels then sticking with them) or loss aversion (being more sensitive to losses than gains).

If you want to improve your finances, the first step should be being aware of which emotions trigger you and then developing habits of moderation and control. While this may sound simpler said than done, this step will put money back in your favor instead of fighting against you.

Emotions and Investing

Emotions can have an enormous effect on our financial lives. For instance, during a market downturn investors may sell investments because they fear further losses even though this loss aversion phenomenon will eventually offset itself with gains over time. Loss aversion prevents investors from making informed decisions with regards to their money.

Many researchers have argued that emotions create biases in decision making (Reference Loewenstein, Lerner and Shklovsky 2002; Gohm and Clore 2000 and 2002). Others, however, argue that emotional influences may actually be beneficial if properly managed.

Peters and Vastfjall (2006) proposed a four-fold classification of emotions’ roles in decision making: they provide information (involving pleasure and displeasure) for preference formation; enable rapid choices under time pressure; increase attention to relevant aspects of a problem; trigger commitment regarding morally and socially significant decisions. Emotions also can influence investment decisions because people place more weight on fears than gains resulting from potential investments (Lowenstein & Lerner 2002; Slovic Finucane Peters MacGregor 2002).

Emotions and Saving

Reorienting how you perceive money can make a significant impactful on your financial future. Acknowledging negative emotions such as fear, guilt, shame or envy and managing them effectively are necessary when making financial decisions that can affect our futures.

For instance, if your upbringing included statements such as “you can’t take it with you when you die” and overspending during tax refund season from family members, you might find yourself spending quickly. By replacing old money scripts with more effective ones and learning to control spending and save more.

Morgan Housel is an award-winning business writer, former columnist at both The Wall Street Journal and Motley Fool, and partner at Collaborative Fund. Through research he came to realize that luck and human behavior play an increasingly crucial role in financial decision making than spreadsheets or analyses alone. His book The Psychology of Money: Timeless Lessons on Wealth, Greed and Happiness highlights 18 associated biases or behaviors which influence outcomes negatively in financial transactions.