Emotions play a far bigger role in our financial lives than many of us realise. Whether it’s the joy of seeing your investments rise or the panic of a sudden market drop, our emotional responses can heavily influence the financial decisions we make. These emotional reactions often lead to decisions that are impulsive, rather than based on logic or sound financial planning.

Morgan Housel, in The Psychology of Money, points out that money isn’t purely a numbers game. Instead, it’s an emotional one. Our relationship with money is shaped by personal experiences, family upbringing, and societal pressures. Understanding how emotions influence our financial decisions is crucial if we want to build and sustain long-term wealth.

1. Fear and Greed: The Two Driving Forces

Two of the most powerful emotions in finance are fear and greed. Greed pushes investors to take unnecessary risks in search of higher returns, while fear causes them to avoid risks altogether or sell investments at the worst possible times.

A study conducted by Dalbar Inc. found that during periods of high market volatility, fear causes most investors to panic and sell at a loss, while greed leads them to chase high returns in speculative markets. Both fear and greed can prevent investors from sticking to their long-term investment strategies, which leads to underperformance. Over the past 20 years, the average equity investor has underperformed the broader market by nearly 4% annually due to these emotional behaviours.

The Global Financial Crisis of 2008 is a prime example of these emotions at work. During the housing bubble, greed drove many investors to take on massive amounts of risk, leading to the collapse of financial markets. Then, as the markets crashed, fear caused panic selling, which exacerbated the downturn.

Housel argues that the key to overcoming fear and greed is perspective. While short-term volatility can be terrifying, keeping a long-term view can help investors remain calm during market fluctuations and avoid impulsive decisions.

2. FOMO: The Fear of Missing Out

The fear of missing out (FOMO) is another emotional driver that impacts financial decisions. FOMO occurs when people see others making gains and feel pressured to jump into investments, even if those investments are risky or overvalued. This emotional response often leads to poor financial choices, such as buying at the peak of a market bubble.

A survey by the Financial Conduct Authority (FCA) found that 37% of young investors were driven to purchase speculative assets like cryptocurrency due to FOMO. The same survey revealed that most of these investors had little to no understanding of the assets they were buying, but felt compelled to invest because others were making significant returns.

The dot-com bubble of the late 1990s was a perfect example of FOMO on a large scale. Many investors bought into tech stocks not because they understood the businesses, but because they didn’t want to miss out on the huge gains everyone else was making. When the bubble burst, these same investors suffered massive losses.

According to Daniel Kahneman, a Nobel Prize-winning psychologist, FOMO is a form of social proof, where people look to others for cues on how to behave. The problem is, this often leads to herd mentality and poor decision-making.

3. Loss Aversion: Avoiding Pain at Any Cost

Loss aversion is the psychological principle that people feel the pain of losing money more intensely than the joy of gaining it. This is one of the most powerful emotional drivers in financial decisions. It leads investors to hold onto losing investments for too long, hoping to recover, rather than cutting their losses and moving on. At the same time, loss aversion prevents people from taking reasonable risks that could lead to greater rewards.

In their groundbreaking work on Prospect Theory, Daniel Kahneman and Amos Tversky found that the pain of losing money is twice as strong as the pleasure of gaining the same amount. This bias explains why many investors are reluctant to sell losing stocks, even when it would be financially prudent to do so.

The Bank of England reports that loss aversion is one of the main reasons why UK households keep a large portion of their savings in low-interest accounts, where they lose purchasing power due to inflation. Although logic dictates that investing in the stock market would offer higher long-term returns, the fear of potential short-term losses prevents many people from doing so.

4. Overcoming Emotional Bias: Strategies for Better Decisions

While emotions are an inevitable part of financial decision-making, they don’t have to control your actions. Recognising when emotions like fear, greed, and FOMO are influencing your decisions is the first step in overcoming them.

One of the best strategies for reducing emotional bias is automating your financial decisions. A study published by Harvard Business Review found that investors who set up automatic investment plans were more likely to stick to their financial goals and less likely to react emotionally to market fluctuations. By automating your investments, you remove the temptation to buy or sell based on short-term emotions.

Another effective strategy is diversification. By spreading your investments across a variety of asset classes, you can reduce the emotional impact of losses in any one area. According to the National Bureau of Economic Research, diversification can reduce portfolio volatility by as much as 20%, making it easier to stay calm during market downturns.

Conclusion: Mastering Your Emotions for Financial Success

Emotions are an inescapable part of human nature, and they will always influence your financial decisions to some extent. However, by understanding how emotions like fear, greed, and FOMO affect your choices, you can take steps to mitigate their impact.

As Morgan Housel points out in The Psychology of Money, mastering your emotions is one of the most important steps to achieving long-term financial success. By staying calm during market fluctuations, avoiding impulsive decisions, and focusing on your long-term goals, you can build a solid financial future.

References:

• Housel, Morgan. The Psychology of Money: Timeless Lessons on Wealth, Greed, and Happiness. Harriman House, 2020.

• Kahneman, Daniel, and Amos Tversky. Prospect Theory: An Analysis of Decision under Risk. Econometrica, 1979.

• Dalbar, Inc. “Quantitative Analysis of Investor Behavior,” 2020.

• Financial Conduct Authority (FCA), “Young Investor Trends,” 2021.

• Bank of England, “Household Savings Trends,” 2020.

• Harvard Business Review, “The Impact of Automating Investments on Investor Behaviour,” 2019.

• National Bureau of Economic Research, “The Benefits of Portfolio Diversification,” 2020.