Interested in the cross-section where psychology and human behaviour meets economics? Want to explore the theory – and the ‘hows, whens, and whys’ – behind real-life financial decision-making? How much do you know about your own financial behaviour?
In business, we should aim to make informed, data-driven, rational decisions that focus on long-term sustainability. This is not always easy, particularly when emotions, cognitive biases, and other psychological factors enter the equation. Whether you’re balancing investment portfolios or navigating volatile markets, it quite literally pays to be aware of the cognitive and psychological influences on money management.
What is behavioural finance – and what does it tell us?
The Corporate Finance Institute (CFI) define behavioural finance as, ‘the study of the influence of psychology on the behaviour of investors or financial analysts.’ Its scope includes subsequent effects on financial markets, and the fact that financial professionals ‘are not always rational, have limits to their self-control, and are influenced by their own biases.’
Behavioural finance enables us to better understand anomalies in the financial market – including bubbles and crashes – and offers insights into decision-making processes. In turn, this can help improve investment decisions, minimise risks associated with financial mistakes, encourage self-awareness, and promote better financial planning.
How does emotional intelligence impact investment decisions?
Emotional intelligence – often referred to as EI or EQ – can have a significant impact on the investment decisions we make and the investment strategies we adopt. It has the power to influence how we each perceive, process, and respond to financial information and stock market fluctuations. In fact, data indicates that organisations that practice EQ are 107 times more likely to thrive – including in relation to money, profit, and the bottom line.
Individuals with high EQ are more adept at understanding and managing their emotions and recognising and influencing the emotions of others. They possess four specific competencies: self-awareness, self-management, social awareness, and relationship management. These competencies are key when it comes to sound, considered money management and investments.
For investors, EQ helps mitigate biases, navigate volatile situations, retain discipline in decision-making, understand drivers behind investor behaviour, and balance risk.
What psychological factors influence financial decisions?
There are various factors that shape and influence how we invest, spend, save, and manage money. Acknowledging the complex web of psychosocial factors that influence financial behaviour can lead to more informed, responsible, future-minded decision-making.
These include: cognitive biases – including confirmation bias and anchoring bias; emotional influences – including fear, anxiety, greed, perceived lack, regret aversion, and herd mentality; behavioural patterns – including mental accounting, status quo bias, and present bias; social and cultural influences – including cultural attitudes towards money; and financial literacy and personal experiences.
What role do cognitive biases play in personal finance management?
Behavioural finance recognises the impact that individual cognitive biases – unconscious psychological ‘shortcuts’ through which we perceive information and interpret the world around us – can have on our economic decisions.
First, let’s look at some common cognitive biases in more detail:
- Confirmation bias – seeking, interpreting, and remembering information in a way that reinforces pre-existing beliefs and discounting contradictory evidence
- Loss aversion – fearing losses more than valuing equivalent gains
- Anchoring bias – over-reliance on the first piece of information encountered
- Mental accounting – navigating money matters based on subjective criteria instead of logic
- Overconfidence bias – overestimating one’s knowledge and abilities, having too much faith in predictions, and having an ‘illusion of control’
- Disposition effect – selling lucrative investments too early and hold on to losing investments too long
- Recency bias – favouring recent events over historical events, data, and long-term trends
- Framing effect – making decisions based on how information is presented rather than considering facts and logic
- Endowment effect – attributing higher value to items we already own compared to identical items we do not own
- Hindsight bias – believing that we “knew it all along” after an event has occurred, or that the outcome was more predictable than it actually was.
The impact of cognitive biases and irrational decisions can be profound. They can influence how your money is spent, your choice of investments, and factors such as your risk tolerance level and how much debt you’re comfortable with.
How can we avoid cognitive biases when it comes to money matters?
Whether it’s a result of flawed thinking, emotion-led behaviour, or psychological shortcuts, all businesses should seek to avoid money and investment mismanagement. Making smarter financial decisions requires business leaders and investors to recognise biases and implement strategies to minimise their negative impact.
Organisations can reduce bias-driven errors of judgement – and improve investment outcomes over the long term – by:
- practising data-led decision-making. Financial decisions should be informed by historical trends, objective, unbiased data, and fundamental analysis. Avoid making decisions based on short-term market trends and movements or intuition.
- increasing bias awareness. If you don’t know which biases you’re vulnerable to, you can’t know how they impact your financial situation and decisions. With each new decision, ask yourself whether biases or emotions are playing a role.
- diversifying information sources. Listen to analyses and sources that challenge your own ways of thinking – and therefore minimise confirmation bias. When evaluating financial opportunities, consider both optimistic and conservative viewpoints.
- adopting a long-term outlook. Impulsive decisions grounded in recency bias or short-term market conditions should be replaced by considered, far-reaching financial strategies and forecasts that are unaffected by emotional volatility.
- clarifying financial goals. Financial professionals who operate in line with predefined criteria – for example, in terms of buying or selling investments – avoid emotional decision-making.
- seeking professional, unbiased advice. Financial advisors – or automated portfolio management tools – can provide a valuable external, objective perspective. They can help manage investments more wisely, bring objectivity and discipline to decisions, mitigate biased, emotion-driven choices.
How to improve financial literacy in organisations
Financial literacy is integral to shaping financial behaviour and should be an important consideration for all organisations. Naturally, it’s critical that budget-holders and those managing business finances know what they’re doing, but it’s also beneficial for employees on a personal level. Those in charge of their finances are likely to be happier and more productive at work, and experience greater wellbeing in general, if they’re on top of their finances.
Not all employees will share the same financial goals, needs, and priorities. Some may need help with fundamentals such as saving, budgeting, and investing, others will need support with more complex issues such as impulsive spending and debt accumulation. Business leaders and managers can help teams to develop better financial know-how by offering a range of heuristic learning resources and support tools that cover various needs and life stages. For example, debt management tools, pensions and retirement planning, financial ‘health checks’, and financial advice more broadly.
Explore cognitive biases and other theories and motivations behind human behaviour
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