How Behavioral Finance Can Help you Understand Why You're Fearful
Updated: Feb 24, 2021
Kathleen Owens | Fiduciary | Financial Adviser | Certified Financial Planner candidate
Our emotions are powerful. We react instinctively when we sense a threat. We know this now more than ever due to the Coronavirus Pandemic. This virus, that we cannot see can cause mental and physical reactions: Constant worry and insomnia can be two symptoms.
Having an understanding of the science behind how we automatically react can help gain perspective and help manage the thoughts and physical reactions to things we can't control.
It is normal to feel stressful during this global pandemic. And if you're one to watch financial news daily, that only feeds into your stress level. Seeing the stock market go up 500 points one day, then go down 700 points the next day, can be distressing.
(my tip to my clients: don't watch the financial news every day!)
Again, it's normal to feel fear during times of uncertainty. However we need to be aware of the fear when making financial decisions. Making financial decisions as a reaction to fear can have long-term negative effects.
Behavioral Finance studies how we view and react to financial situations. Most of our reactions revolve around:
FEAR of LOSS
We fear losing something we have more than gaining something that we don't currently have.
Daniel Kahneman, author of the book, Thinking Fast and Slow, has spent decades researching how we think. Kahneman is a psychologist and won the Nobel Prize in Economics for his mind-blowing research about how our emotions and biases get in the way of our rational thinking.
Here's one test that he conducted:
You are asked to play a game
A coin is flipped: if the coin reveals the "Heads" side, you win $1,000. If "Tails is revealed, you lose $1,000.
Would you play this game? Yes or No?
Another game is offered
A coin is flipped and this time, if "Heads" is revealed, you will win $2,000. If "Tails is revealed, you will lose $1,000.
Would you play this game? Yes or No?
The result of this test was that all of the participants chose the game that they had the chance to win $2,000. Even though the odds were the same in both games: a 50-50 chance of winning or losing.
"People feel losses more acutely than gains. The ratio of intensity is; they feel the loss twice as much as the gain" - Daniel Kahneman
Thus, you will only take the risk of winning $2,000, because it seems "worth it" compared to losing $1,000. The extra $1,000 you would win overcomes your loss aversion to losing.
That's why lotteries are so successful. When you buy a lottery ticket each time for $2.00, that seems totally worth the risk of losing your $2.00 for the chance to win millions.
The possibility of winning millions versus losing your $2.00 totally erases your loss aversion.
And, of course, it would be incredibility awesome to win millions.
However, people do not usually spend just $2.00 per year on lottery tickets. Some people spend hundreds and thousands of dollars yearly on lottery tickets. When you look at the odds of you winning the lottery, your odds of winning are very, very low. People would be better-off investing their hundreds and thousands of dollars in an investment that will give them any sort of return on their investment.
And to put the attraction of lotteries in perspective; in 2017, Americans spent $71.8 billion dollars on lottery tickets.
There are strategies that can help you navigate successfully during fearful times and make well thought-out financial decisions. I use behavioral finance with my clients to help them see if their decision might be a reaction to fear versus a decision based on facts. It's been really helpful to my clients and to me as well to take the time to discuss how emotions are a normal part of the decision making process and how we can manage emotions to make good decisions.
Thanks for reading my article! I hope you found it helpful.
Kathleen Owens - Fiduciary | Financial Advisor | Certified Financial Planner candidate