The Role of Emotion in Finance
Money is something that can trigger emotional highs and lows. A two-edged sword that can bring both joy and anxiety to its wielder. And when it comes to making financial decisions, our emotions can sometimes get the best of us. A study conducted by Nobel Prize-winning psychologist Daniel Kahneman showed that the majority of people make financial decisions based 90% on emotion and only 10% on logic. This means that emotion clearly plays a big role in the world of finance.
But what if we could better understand our emotions and learn how to control them? Would that help us make more informed and rational decisions about our money? Let’s find out!
The Loss Aversion Phenomenon
Did you know that loss aversion is a thing? It’s a psychological phenomenon where we feel the pain of losses more than the pleasure of gains. In other words, we’re more likely to make decisions that avoid losses, even if it means missing out on potential gains.
We in the crypto industry witness this phenomenon all the time. People panic selling left and right whenever the market falls. The anxious feeling of seeing your investments drop in value prompts people to sell at a loss and miss out on greater gains.
A good example of this would be the Bitcoin crashes over the past years. How many times did Bitcoin drop drastically, and the people motivated by fear, start selling as a response? Yet, we see Bitcoin bounce back from all those crashes to the regret of those who sold theirs. It is better to keep your emotions in check to not cloud your mind in making financial decisions. Otherwise, you might miss out on something big.
The Endowment Effect
There are times that we must sell at a loss. Not all investments will thrive to the amount we expect them to be. Our emotions also play a huge part in how we cling to an investment. It leads us to decisions where we unwisely hold onto something while disregarding any sign or advice that tells us to sell already.
There is something called the “endowment effect,” which is when we place a higher value on something simply because we own it. This can lead us to hold onto losing investments for too long, rather than selling them and taking the loss. The recent Luna crash is a good example of this phenomenon. Many people lost so much in this crash due to holding on for so long to this asset.
It is important to have rational thinking about when to keep on going and when to let go. Listen to advice and evaluate them with an open mind to make better decisions. If you let your emotions call the shots you will most likely end up making the wrong choices.
Are you over-risking or under-risking?
A good question to ask yourself is “are you over-risking or under-risking?” Play safe and you might lose on potential gains. Take too many risks and you might lose it all. Are you letting your emotions make the decisions? Evaluate yourself and see if you are dwelling in one of the phenomena mentioned above.
Becoming aware of our psychological biases can help us make better choices with our money. Next time you’re feeling anxious about a financial decision, take a step back and try to understand what emotions might be influencing your choice. It could help you avoid making a costly mistake.