Revealed: The Role of Psychology in your Financial Decisions

Emotions are very much a part of our lives. This virtue is the one that differentiates you and me from the other living beings on this planet.

As humans, you and I are influenced by our feelings of fear, greed, and uncertainty when making Investment Choices. This can lead to irrational and impulsive decision-making, which can ultimately result in financial losses.

How do we make rational decisions in our Financial Life overcoming our emotional guilt?

Table of Contents:

1.)Why Do One-Size-Fits-All Financial Plans Don’t Work?
2.)Do we need to be really Financially Smart?
3.)Walk the talk and its reality on our Financial Life?
4.)Emotions vs Rational Financial Decisions
5.)Irrational Decision due to Financial Loss
6.)How to be a Rational Decision Maker in your Financial Life?
7.)Why does One-Size-Fits-All never work in Personal Finance?

• Replicating Finfluencers Portfolio?
• Never chase trends in your financial life

8.)Intelligence vs. Financial Literacy

• Emotional Investors
• Rational Investors

9.)Why do people deviate from their Financial Goals?

• Do not be Misled by Enticing Financial Opportunities
• Insufficient Emergency Funds
• Where is the Knowledge-Action Gap in your Financial Decisions?
• SIP Mistakes

10.)What do we lack and what are the Action Items for our Financial Life?
11.) Bottom line

Why One-Size-Fits-All Financial Plans Don’t Work?

This also leads us to our next question. Have you ever wondered why one Financial Plan works out for everyone?

In this fast-moving world and with the advent of technology and loads of information around us, managing our finances should be quite easy, isn’t it?

We have loads of content from influencers and trendsetters out there on the web who can help us manage our finances, right?

Can’t we just stick to some of their model portfolios and just replicate them?

Do we need to be really Financially Smart?

Do we need to be Financially Smart to achieve our Financial Goals?
Do we all need to perform a fundamental or technical analysis of our Investment Portfolio, surf through all results of the stocks, listen to con calls of the companies and pick up stocks/funds and invest to build wealth?

Walk the talk and its reality on our Financial Life?

The appropriate emergency corpus that we should have before we start our Investment Journey is a minimum of 6X our monthly spending. But how many of us have set aside this for our emergency needs?

Why do people not make this Investment their Prime focus?

In this article, let’s debug the reasons and also study the psychology behind all these financial decisions and the methods to improvise them. Grab a snack and let’s dive in.

Emotions vs Rational Financial Decisions

“Some lessons have to be experienced before they can be understood”

— Michael Batnick

First of all, let’s admit it. None of us is 100% right when it comes to making decisions regarding our Financial Goals. But we all make some sort of decisions in haste. Isn’t? But at what cost?

We would be lucky if the cost we paid for our hasty Financial Decisions are small. But what if it is enormous and takes a toll on your Investments and peace of your mind?

Irrational Decision due to Financial Loss

Recently, there was a report on the death of a research scholar ending his life due to the financial losses he made in the stock market. Generally, people involved in the research and development sector are pretty knowledgeable and rational people. They have the virtue to be patient and thrive in high-pressure situations all along their lives.

But in this case, it has resulted in his suicide. He had fallen prey to greed and he has since lost his money. His emotions got the better of him and made him take this adverse step.

Likewise, many people have lost it in the stock markets and have gone bankrupt. But if we analyze the reasons, the one common thing we can find is that those who lost financially always took their financial decisions emotionally.

Yes, we agree that losing money can be hard to digest and your entire life may be on the line. But is it worth losing your life over this? This is where people need to be rational.

But is rational decision-making regarding your finances so simple?

Not at all. An emotional decision taken by one may seem right to him at a point in time and the same decision may not appear rational to others when they see it from outside. We will have to put ourselves in their shoes and analyze the situation.

How to be a Rational Decision Maker in your Financial Life?

One way to improve our rational decision-making is to take a step back and analyze our financial situation objectively. This involves setting aside our emotions and looking at the facts and data involved in our Investment Decision. We can also seek the advice of trusted friends or professionals such as a Financial Advisor to gain a different perspective and challenge our assumptions around Money.

Personal finance is always a changing journey. You might have specific Financial Milestones you might want to achieve within a specific period. But our Financial Life may take a hit due to;

• Market Crash
• Unemployment
• Financial Loss in business
• Medical Expenses
• Rising Inflation

It helps to always be prepared for Financial Loss as it is possible to make improvisations to your Financial Plan at every step of your Investment Journey.

Additionally, it’s important to have a clear set of financial goals and priorities that can guide our financial decision-making process.

By having a plan in place, we can avoid making impulsive decisions in our Financial Lives that are driven by our emotions.

Why does One-Size-Fits-All never work in Personal Finance?

Personal finance is different for each individual because everyone has different financial goals, priorities, and circumstances. What works well for one person may not work well for another and financial decisions should always be based on individual circumstances.

There is no one-size-fits-all approach to personal finance, and what works well for one person may not work for another

The investment goals can be influenced by factors such as;

• Age
• Family status
• Location
• Economic Background
• Time Horizon of our Financial Goals
• Risk Appetite

For instance, you may have started saving at the age of 21, whereas your friend could have started late. So, at this point, you may look for different investment choices whereas your friend may be a bit defensive at the beginning. So, the investment choices differ here.

You are right in your judgment and so is your friend. Another friend of yours may be paying his educational loans after graduation and may not be saving as much as you do. So, the perspective differs for each individual and may not be compared.

• Replicating Finfluencers Portfolio?

Now, let’s apply the same analogy to people who try to replicate the portfolios of financial influencers on social media.

The influencers usually are HNI’s and are fairly unknown personally to the commoners. So, trusting them and investing your money is a risky affair. More so, we do not know their risk appetite. They may have several streams of income and can take a risk concerning certain investments. Can you afford to do the same?

• Never chase trends in your financial life

There is this billionaire who is a prominent entrepreneur and innovator who has founded several successful companies in technology and is one of the wealthiest people on planet Earth. One fine day he puts out a tweet about a cryptocurrency and the value of the coin grows multifold. Common people out there considered it to be the next big thing in crypto and invested a lot of money in this particular coin.

After some time, the same billionaire tweets against the same currency, and its value loses more than 75% of its value in the next 1-2 weeks. Many people had invested at the high and lost their investment. This is yet again a scenario when your emotional thinking outwits your rational side and made you chase the trend.

Irrespective of the investment instrument, can we as individual investors afford to lose our entire wealth in such pump-dump scams listening to finfluencers?

Well, no. So why try to copy their investment portfolios and burn your fingers?

Rather, take cues from them and do your own research.

Intelligence vs. Financial Literacy

We don’t have to be smarter than the rest;

We have to be more disciplined than the rest.

-Warren Buffett.

Many people in this world are deprived of basic education. Not many people have basic financial knowledge about managing their money and saving for their financial goals. But how do you think these people manage their finances? Do you think they cannot manage their finances and do not set financial goals?

Financial success is a multifaceted process that is influenced by a range of factors, including intelligence, financial literacy, soft skills, and personal circumstances. While some people may assume that intelligence or wealth is the sole predictor of financial success, this may not be true and reflective of real-world facts.

Being smart or wealthy is not a guarantee of financial success. For example, a highly intellectual person may lack basic financial literacy, making them vulnerable to poor financial decisions. Wealthy people may struggle financially if they lack the discipline or financial literacy to manage their wealth effectively.

• Emotional Investors

Let’s compare different person’s lives to further reinforce our thoughts.

• Sir Issac Newton-One of the greatest scientists to have lived on Earth
• Mark Twain– The renowned American author and humorist
• Mike Tyson: The former heavyweight boxing champion
• Mark Cuban: The billionaire entrepreneur from Shark Tank
• Nicolas Cage– One of the highest-paid actors in Hollywood during the 1990s

What comes to your mind when you hear these names?

Great scientists, Legendary artists, the Greatest of all time in a league of their own, the Smartest people on earth, and so on right?

But what if I told you that these people have lost considerable wealth in stock markets and financial scams because they were not able to take a rational financial decision on their holdings?

Newton invested in the South Sea Company. However, Newton later developed concerns that the stock market was becoming overvalued, and he believed that the South Sea Company’s stock price was destined to collapse. Despite this, he decided to reinvest in the company at a higher price in 1720. Unfortunately, his investment proved to be ill-timed, and when the stock price did indeed crash later that year, Newton reportedly suffered losses of around £20,000 (equivalent to millions of pounds today).

Mark Twain, the renowned American author, and humorist invested heavily in a new typesetting machine called the Paige Compositor in the late 1800s. Twain believed that this machine would revolutionize the printing industry and make him a lot of money. He poured a large portion of his fortune, as well as money borrowed from friends and family, into the development of the machine.

However, the development of the Paige Compositor was beset with problems, delays, and cost overruns, and it failed to live up to its promise. Twain’s investment in the machine drained his finances and left him heavily in debt. He eventually had to declare bankruptcy in 1894 to get out of his financial troubles.

Mark Cuban: The billionaire entrepreneur and Shark Tank star has acknowledged that he has made emotional investment decisions in the past, such as holding on to a stock for too long or investing in a company just because he liked the product

The list goes on and on. So, what do we get to arrive at here? The above-mentioned people are one of the most renowned persons in their own areas of expertise.

But still, they lost so much of their wealth as their emotional decision-making process took precedence over their rational decision-making in their wealth-building process. If they had taken a moment to think before making those hasty financial decisions, they could have well avoided their downfall.

• Rational Investors

Now let me introduce a couple of more people.

• Oseola McCarty- A washerwoman who made it big with her meagre income
• Ronald Read-A Gas station attendant turned around his life by simple investing

A washerwoman and a gas station attendant in comparison with Isaac Newton and others?

Oseola, with no formal education and no one to guide her, has made it big. Two things made her who she was. First was her knack for investing whatever she earned and the second one was to do it consistently.

From all the cents she earned drying clothes to the inherited money from her aunt she just did one thing, Invest in her bank account. By 1995 she had amassed $280,000 and donated $150,000 of her savings to set up a scholarship fund for underprivileged students.

Read again, she was a washerwoman who never went to college. She did not even finish sixth grade. She just did one thing. Invest consistently and never back off. She never let emotions come in the way of her investing.

Did Oseola fare better than Sir Issac Newton and the others? Yes, She did!

Ronald was an army veteran until 1945. After his national duties, he started working in a gas station and then as a janitor in a retail store.

Like Oseola, he kept working hard until he was in his 60s and continued to invest all his meagre earnings. He never lived a luxurious life and was content with what he had. He also invested in blue chip stocks which are considered a haven. By just simply investing in safer options, Ronald had accumulated a wealth of more than $8 million.

Oseola and Ronald emerged as big winners in their Financial Lives when compared to Newton and others. They didn’t even have basic education, no investment advisors, and were not born with a silver spoon as such but still came out on top of the others.

Here are two people who without any knowledge of personal finance managed to eclipse the likes of Newton, and Mark Twain who are the powerhouses in their respective domains. With the limited resources at their disposal, both of them have won over some of the world’s most eminent personalities.

Is there any other profession where a newbie can overtake a seasoned professional with little or no knowledge? Don’t think it is possible. That’s the beauty of personal finance.!

If Oseola and Ronald can make it big financially, don’t you think we also make it out?

Why do people deviate from their Financial Goals?

• Do not be Misled by Enticing Financial Opportunities

One of the most important aspects of personal finance is to jot down the different financial goals and invest accordingly to achieve them. Walking the talk means taking concrete steps to manage your money wisely and make progress toward your financial goals.

But in reality, this is challenging. When we start to invest in our financial goals we face endless challenges, especially with the critical decisions we will have to take in the due course of time. These challenges may include choosing the Right Investment Instrument to invest in and choosing the tenure. If we let our emotions rule our financial decisions by buying into the hype and investing without proper research, it will backfire.

For the past two years, Adani Stocks were on the surge by dominating the market. But after the in-depth Investigative Report released by Hindenburg about the Adani group, there has been a steep fall in the Adani Stocks leading many people who invested in them to go into a huge financial loss.

There has been another instance in the past when the Saradha Chit fund scam rocked our nation back in 2013. Many people who invested in this Ponzi Scheme had to see their hard-earned money get wasted back then.

These are some examples of how there have been instances when a certain Investment Instrument was producing great returns within a short period and crashed terribly.

These examples make our case evident of how we need to stay disciplined to the core and not be misled by other enticing opportunities.

You can read our resourceful article on “How to protect yourself from misleading or fraudulent Investment Schemes?” for better insight into making your Future Investment Decisions.

• Insufficient Emergency Funds

Morgan Housel in his book Psychology of Money quotes “Americans spend more on them than movies, video games, music, sporting events, and books combined. Mostly poor people buy them. The lowest income groups spend an average of $412 in a year, four times the amount spent by the higher income group. Those buying these lotto tickets cannot come up with a $400 emergency fund when needed”

Though lottery wins can immensely help you, it’s important to remember that the odds of winning the lottery are extremely low, and the vast majority of people who buy tickets will not win. So just ask yourself a question here. Do you want to take a chance to construct your emergency fund with this money or buy lotteries that have a winning chance of one in a million? Of course, we are rational decision-makers, aren’t we?

• Where is the Knowledge-Action Gap in your Financial Decisions?

Does everyone know that we need to save for the rainy days ahead in our lives? But why do we not do it as easily as we speak?

When it comes to emergency funds, you might be aware that you need to save a certain amount of money to prepare for unexpected expenses, but you may not be sure how much you should save. You may conduct research on the internet, consult with friends or a financial advisor, and come across various opinions, which might make it difficult to determine the best course of action. Despite the urgency of the situation, you may hesitate to make a decision, which only prolongs the worry and stress related to the issue.

Meticulous planning and periodic reality checks help in faster decision-making. The sooner you make a decision, the simpler it tends to be. This applies not only to emergency funds but to all scenarios in investing.

• SIP Mistakes

We identify our financial goals and start investing in them, via SIP. The ideal way to invest in a SIP is to step up the SIP at least by 5% once a year. But how many of us do this?

We all know that SIP helps in compounding and creates magic in our latter years of investment but still fail to do this step up. Isn’t it high time that we walk the talk with our investment aspirations?

Above are some of the mistakes that we can think of. There may be so many other scenarios where we fail to do justice to our initial thoughts when we started our investment journey. You can read through some of the SIP mistakes and how we rectify them in our blog.

What do we lack and what are the Action Items for our Financial Life?

He who fails to plan is planning to fail

-Winston Churchill

Centuries have gone by since humans started civilization. Since then, we have improvised in every aspect of our lives. We all know how the wheel evolved through centuries.

We have made significant progress in various fields, including agriculture, medicine, and whatnot, through collective trial and error. However, there is still a long way to go when it comes to improving our financial literacy and behavior.

But given all the points we discussed earlier, how do we arrive at a conclusion if a decision or an investment is the right thing to do?

How to become a Rational Investor and level up our Investment Strategy?

There is a Simple checklist given below which you can follow to help you stay away from taking emotional decisions in your Financial Life.

• Always determine the motivation behind your Financial Decisions; Whether it is an Emotional or logical decision.
• Completely analyze if the Pros outweigh the Cons of your chosen Investment Instrument.
• Check if there is any Emotional Bias involved in the decision you made.
• Evaluate if your actions align with your financial goals.
• Always make sure that all the risks are identified and mitigation plans are in place before taking an Investment Decision.

Once you can safely say that your investment decision aligns more than 80% with the above checklist, then go for it.

Ultimately, the key to becoming successful financially is to stay focused, disciplined, and committed to a clear and specific vision for the future, even in times of short-term distractions or setbacks. By doing so, you can build long-term financial security and achieve your financial objectives over time.

Bottomline

Personal finance is simple to define. But following the rules laid before without any distraction isn’t an easy task as such. Reality is much different from what we see in books or the backtest results. But somehow emotions take us over and we tend to make mistakes. Though it may seem to be a smaller mistake, it may come back to haunt us in the latter stages of our investing journey.

So, what type of investor do you want to be?

Do you want to be an emotional investor or a factual reality investor?

The choice is yours.
If you need guidance on making the right choices when it comes to your financial life, it is always advisable to consult with a Professional Financial Advisor to achieve better results.