Navigating Financial Decision-Making Challenges: Exploring the Behavior Gap and Emotions
November 20, 2023 Author: Tess Downing, MBA, CFP®, Complete View Financial
Making financial decisions is hard, even for people with rational decision-making. So, why do those with rational decision-making struggle with financial decisions?
This idea is similar to what we call the driving bias. Everyone thinks they’re a good driver, even when they’re not. Statistically, it proves that a majority of drivers on the roads are overconfident when it comes to their driving capabilities.
A lot of times, poor decisions, including financial ones, are made when going through emotional stress, such as fear or anxiety. People tend to make rash decisions and quicken decision-making when they feel outside pressures from their emotions or the people around them.
Also, people make decisions after experiencing a lot of growth or a sudden decline. Here are some common financial behaviors that happen because of the factors we have mentioned above.
The Behavior Gap
The behavior gap is the difference between a sound financial decision and what decision we decide to make. With emotions being a factor, many people tend to miss out on higher-return investments, creating a gap between their lower returns and the return they could have received.
What Can Cause a Behavior Gap?
#1: Excitement when Stocks are High
When stocks are high, many investors are tempted to increase their risk when making investments. They want to capitalize on these higher stocks and gain from emerging investments. With the market not being stable, these increases can happen occasionally, causing investors to restructure their portfolios during times of upswing. Typically, if an investor is following the upswing, they are also following the decline and may try to time the market despite unpredictable shifts and changes.
#2: Fear when Stocks are Low
When stocks are low, the market tends to make more secure financial decisions and pick decisions that involve less risk. An everyday activity during periods of low stocks is to sell, causing investors to miss out on potentially large long-term gains.
#3: The Search for Alpha
Alpha stands for above-average returns. People will do anything to make money and strive to be at the top of the investing market. The emotional desire to be at the top encourages many investors to look for these “alpha” level returns. However, when searching for these returns, our emotions likely lead us down the wrong path. Underlying emotional desire when pursuing large amounts of money can lead to unwise behaviors in response to emotions if left unchecked.
#4: Anxiety and Focus
Viewing our lives through current circumstances is normal. However, one emotional response to an event is letting the moment consume us. During these times, people find it hard to think about the long-term and to remember to use logic when making decisions. It’s important not to make rash decisions and to think through all your options before taking action.
How to Lessen Your Behavior Gap
With the constant fluctuation in the market, the only thing we can control is our financial strategy. It’s essential to understand your emotions when making financial decisions and to try and look long-term when going through a tough decision making process. Be sure to always reach out to your advisor for further help and clarification throughout complicated decision-making processes.