- Fear is a powerful emotion. And when it comes to your finances, it can end up costing you.
- Instead of “trusting your gut,” create a long-term strategy and stick to it. Working with a professional can help.
- A mindfulness practice can also help you separate fear and anxiety from your money decisions.
Some of the most common money mistakes people make are not due to the inability to actually handle their finances. The real problem? The loving of emotions around your money in check.
Success as an investor, in theory, comes down to logical principles. Think rationally about concrete financial strategies, such as asset allocation, diversification, and portfolio construction, and you should see your investments grow exponentially over time using compound returns.
But investors are not robots. They are people. As Richard Thaler, a Nobel Prize-winning economist who focuses on psychology and how people make choices around money in real-world conditions, put it, “Economic actors are human and economic models must incorporate that.”
So by learning how your emotions affect your financial decisions — and how to manage that while managing your money — you can gain confidence in both your day-to-day choices and your long-term decisions to build your wealth.
The most common emotions that stand in the way of smart money management
Fear and anxiety are perhaps the most prominent emotions that stand in the way of good financial decisions. That’s understandable: money is a valuable resource in our society, and something that you will probably always need in some amount of money. It’s normal to be afraid of losing it.
But that aversion and fear of loss can make us do very irrational things. It gives us tunnel vision. We lose sight of the big picture and make short-term choices while thinking about a long-term strategy.
We forget that the stock market has rewarded long-term investors, or those who invest and stay decades invested. (On the other hand, it tends to punish those who try to time the market and outsmart all other market participants.)
Fear can also make us more prone to recency bias — or the mindset that what happens now will continue to happen in the future. Our fear of running out or not having enough blinds us to the fact that recessions are temporary and usually followed by periods of economic growth.
Other harmful emotions are avoidance. Ignoring your finances altogether or thinking you’ll find your strategy once you’re “closer to retirement” means you’re missing out on opportunities to build wealth now†
Financially successful people know that their greatest asset is time, so they don’t put off important financial decisions or actions to ‘someday’ handle. They are proactive, engaged and motivated to manage their money well now – not later.
And then there is hubris. Overconfidence can blind you to the obvious and cause you to make casual mistakes. When people are more confident than they should be, they are less able to accurately calculate probabilities and are more likely to underestimate risk.
Why working with your gut doesn’t work in the financial world?
Your emotions can lead you to make mistakes, but what about trusting your gut or listening to your intuition?
It will probably get you in trouble too. That’s because of some cognitive biases designed to help our brains make quick decisions, but unfortunately they often lead us astray when we’re in the financial world.
Things like our preference for action can cause us to make mistakes; this is the urge to do something even if the correct answer is to step back and do nothing.
This often appears when
fears reached new heights. We feel like we need to prepare, we need to avoid disaster, we can’t just sit and do nothing!
But when it comes to your investments, tinkering with your portfolio and deviating from your set strategy can slow your progress. Or worse, selling your positions at the lower end of the market could lead to you capturing losses at the worst possible time.
Hindsight bias is another that often upsets people when it comes to:
† It involves hubris to let people make big mistakes because they start to think the right steps are obvious.
And they are… looking back, after an event has occurred. Retrospective bias makes us feel that the answer was clear before the event. We forget how we felt before we knew what we know now.
What poker player Annie Duke calls “resulting” can also throw our minds into disarray. It happens when we put too much emphasis on an outcome rather than the decision we made before we knew what was happening. If we see positive results, we assume it was the result of a good decision (and vice versa).
Meanwhile, we ignore the role of chance. We don’t remember that sometimes a good decision can still lead to a bad result, simply because of bad luck. On the other hand, we attribute good results to how smart we are, even if we made a bad decision and got lucky despite it.
3 ways to control your emotions as you progress toward financial success
Financial success is always an uphill battle. But if you can reduce the noise and distractions your own mind can generate, that will make it a little easier to make the right decisions and choices while you’re at it. There are a few strategies you can use to do just that:
Set it and forget it (to a point)
It is important to spend time developing a specific, consistent investment strategy that you can adhere to over time. That will take some work and it’s not easy, but once you go through the process, stick to your strategy.
That means not getting caught up in current events or short-term news cycles, being distracted by what “everyone” is doing, or letting your emotions distract you from the path ahead. Keep in mind that financial progress is a long-term game.
Automate what you can (such as contributing to savings and investment accounts) so you don’t have to make the same decision over and over, and aim to review (and rebalance) your investment accounts periodically, but infrequently. Quarterly or semi-annually is usually sufficient.
While literally forgetting your finances is impossible and not recommended, you don’t have to obsess daily. This can be more harmful than helpful.
Practice mindfulness and self-awareness
It may sound strange for a financial planner to
practice to improve your money management, but as we’ve already discussed, your emotions can dictate your actions, and emotional decision-making often leads to losses.
You can’t control your emotions if you drown in them. By increasing self-awareness, you can avoid making long-term decisions based on short-term feelings.
Everyone is prone to various mental errors and behavioral biases that cause even seasoned investors to stray from a solid, rational strategy from time to time. And while knowing something isn’t the same as practicing it in your life, you have to start somewhere.
When it comes to managing your emotions around money, that premise is awareness of what’s going on in your head — and where you’re most likely to fall victim to your own psyche. Know your weaknesses, and you’re more likely to confidently steer around them.
Working with a professional
Part of the value of working with a professional financial planner is having an objective third party with an outside perspective. An advisor can provide you with technical know-how and strategies that you can use, and act as a sounding board, second opinion, another set of eyes to check your blind spots, devil’s advocate when you need to think about complex decisions, and more.
A good advisor does not only give advice. They ask the right questions to help you understand what you want and why. They then help you create a specific financial plan to achieve those unique goals and outcomes, keep you on track and avoid mistakes as you progress.