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Financial management

The psychology of money and emotion

Emotions and investing are closely linked. Learn about the psychology of financial planning and how to factor emotions in investing decisions effectively.
5 minute read
  •  
December 01, 2023
Financial management
Financial wellness
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Article
Behavioral economics

How to make better financial decisions

Have you ever gotten emotional about money? Even the most successful, rational investors sometimes experience feelings of anxiety or euphoria when their money is involved.

Why? You’re human. 

Emotion gets a bad rap when it comes to investing or other financial decisions. In fact, a lot of experts will tell you to remove emotion from investing. But that's not really possible—and not really necessary.

"Especially in stressful times, what's important is that you're aware of emotional triggers and how they can affect you," said Chuck Riley, a senior wealth advisor certified in financial psychology and behavioral finance.

Markets and Emotions

Vanguard Investment Advisory Research Center.

Investing is emotional because we're human. Our emotions can take us in all kinds of directions in response to what the market is doing. That can make things tricky because sometimes the best thing to do is the opposite of what our instincts tell us to do. When the market is doing great, it feels great. We feel optimism, excitement, even euphoria. Our instincts might tell us to buy more because we feel invincible. It feels like the bull market will last forever.

But that's the moment in the market cycle where we're actually the most vulnerable because the market will take a turn at some point. It's a normal and expected part of the cycle. When the market does go into a downturn, we might feel anxiety, then fear, and eventually desperation and panic. And in those moments, our instincts might tell us to get out of the game entirely, even though that may not be what's best for our long-term plans.

When things feel chaotic, and we're only hearing bad news, it's easy to miss the fact that the market's lowest points are really the moments that hold the most opportunity for investors. It's just like the saying goes. The night is always darkest before the dawn. But on the way back up, things aren't that much easier, because you never quite know when the good times will return or how long they'll last when they do return.

It's important to zoom out and stay focused on the bigger picture. Successful investing isn't about reacting to what happens in the market day to day. It's about setting goals and putting a long-term plan in place that you'll be comfortable sticking to no matter what the market is doing. And you don't have to feel like you're making these life-changing decisions alone.

Your advisor can help keep things in perspective during the good times and the not-so-good times and help you make decisions that are right for your goals. We're on this journey together. And together, we'll move forward. 

Key takeaways

  • See how emotion and investing go hand in hand. Vanguard research has shown that about 40% of the value an advisor provides their clients is emotional.*
  • Understand the psychology of investing and why emotion can be heavily involved in making financial decisions.
  • Discover strategies for balancing emotion and logic.
  • Learn how Vanguard advisors can support your financial decision-making.

What happens when you make a decision?

Behavioral economists, psychologists, neuroscientists, and others are doing research every day to learn more about how we make decisions, including important financial decisions.

Researchers in neuroeconomics, an outgrowth of behavioral economics, have found that rational, logical decisions are controlled by the prefrontal cortex. And when we're making decisions based more on emotion, the limbic regions of the brain are in control.

Hormones also play a part. When we're faced with making a choice, the stress hormones cortisol and adrenaline are released.

Interestingly, it turns out to be a bad idea to try making decisions based solely on logic—patients with injuries to the parts of the brain that integrate emotion and thinking repeatedly make objectively bad decisions even though their cognitive faculties are intact. The research suggests that emotions play a necessary role.

Emotion and investing go hand in hand. After all, emotions often motivate us to save. Love for our families, a need for security, and our hopes for the future are all powerful drivers when it comes to investing.

How do you know when emotion is leading you in the wrong direction?

So we know emotion and logic need to work together when you make choices. And we'll share some tips for balancing them. But first, here are a few things to watch out for.

Remember that emotions relating to one event can influence your decisions elsewhere. For example, a disagreement with a loved one, a promotion at work, or an upcoming reunion could all spill over into your investment decisions. (Researchers have correlated stock market performance to everything from the amount of sunshine on a given day to a country's elimination from World Cup soccer.) This might be especially relevant in today's world, when many of us have our anxiety turned up on a daily basis by global news and developments.

Be aware when you're faced with content intended to provoke an emotional response. News headlines get more attention when they appeal to feelings like fear. If you're seeing stories about, say, soaring inflation, consider the facts and whether taking action would actually be helpful or just part of an emotional response.

Finally, remember that it's not just "bad" emotions that can burn you! For example, if you're feeling extremely confident, it might lead you to take more risk. Behavioral psychologists have found that this connection can be especially powerful after a "near miss"—when things almost go horribly wrong but come out okay, leading you to feel invincible.

What is emotional investing?

You often base investment decisions on the ebbs and flows of the economic market. Emotional investing is when your cycle of market emotions influences your investment decisions.

By following strategies that can help balance emotion and logic, you can avoid making emotional investing mistakes. Reframing decisions, enacting a waiting period, becoming in tune with your thoughts, and holding yourself accountable are just some of the ways to balance emotion and logic. 

Emotion and investing go hand in hand

After all, emotions often motivate us to save. Love for our families, a need for security, and our hopes for the future are all powerful drivers when it comes to investing.

Acknowledging that our emotions are part of what drives our behavior and comfort level with investing is valuable. To anticipate how emotions might affect your investing behavior and to prevent emotional investing mistakes, ask yourself questions like these:

Do I hate losing even more than I like winning?

Do I make assumptions about the likelihood of something happening based on whether it's happened to me before?

Am I more comfortable keeping things the same rather than making changes?

Do I tend to respond to uncertainty by forcing an outcome just so the uncertainty disappears (for example, selling when an investment has lost money and locking in a loss)?

Strategies for balancing emotion and logic

In their research, psychologists have found that the most obvious strategy—don't get emotional—doesn't work. So what does? Here are a few research-based tactics you can try.

Flip the script. Reframing decisions can help you focus on positive emotions. For example, many retirees are hesitant to spend their savings—they may be worried about seeing their balances decline or feel guilty about becoming a "spender."

"If I sense hesitancy on the part of my clients to spend from their savings, we dig into why that's the case," Chuck explained. "Things like the way money was handled growing up, or traumatic financial events like a job loss or death of a spouse, can weigh heavily on someone's money perspective.

"Even if those circumstances are completely different now, they can subconsciously undermine success. So once we've surfaced those emotions, we can come up with a new script—I deserve to enjoy what I've worked hard for or I'm still responsible with my money, but now it's reflected in different ways."

Enact a waiting period. Emotions may have evolved to draw attention to situations that demand immediate attention. They certainly can make any decision feel urgent and critical. Many people find that they can and should reevaluate their thinking once they return to their calmer baseline—which is almost guaranteed to happen given a little time.

Know thyself. Mindfulness, meditation, and journaling have become increasingly popular lately, but knowing your own mind has been a solid piece of advice since Socrates' time. Research has shown that people with high "emotional intelligence" (being aware of and using emotion to enhance thought) are better at screening out the effects of emotion when making decisions. You can get more in tune with your thought patterns in any number of ways, so do what works for you.

Be accountable. When people know they'll need to explain and defend their decisions to someone else, they naturally focus on the rational reasons for the decision and minimize the emotional ones. "Having a trusted sounding board can help you ensure your logic is as solid as possible. This is potentially the most important role I play as a financial advisor," Chuck said.

Work with your emotions as you invest

Learning more about what influences our behavior is a great first step in recognizing when we're making decisions based primarily on our emotions rather than on logic and reason.

But we shouldn't discount our emotions—they play an important role in investing. After all, they're often what drive us to invest in the first place: love for our family, hopes for their future and ours, pride in our accomplishments. Harnessing those emotional drivers can help motivate us to save.

of the value an advisor provides their clients is emotional—feelings of confidence with their portfolios, satisfaction with their choices, and excitement for the future.*

"As an advisor, I respect how important my clients' emotions are. In fact, Vanguard research has shown that about 40% of the value an advisor provides their clients is emotional*—feelings of confidence with their portfolios, satisfaction with their choices, and excitement for the future," Chuck said.

So go ahead and feel your feelings. And balance them in whatever ways work best for you.

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*Source: Vanguard, The Value of Advice: Assessing the Role of Emotions, March 2020.
 

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