March 1, 2024

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What is financial psychology and how emotions influence investment

People do not always make choices rationally, and the economy is no exception. Financial psychology is the branch of psychology that studies our behavior when making financial decisions, taking into account the emotions, the influence of the context and the cognitive biases that intervene in the process. Also known as Behavioral Finance (or behavioral finance), its teachings are essential to take care of financial health and plan for the future .

Having good financial health means achieving well-being that is achieved through good management of the personal, family or business economy to be able to face unforeseen events and achieve vital and future goals. There are eight indicators that allow for diagnosing whether a person’s finances are healthy.

Economics and psychology need each other to explain how the brain works when making economic decisions. “Without economics, psychology lacks analytical structure and purpose, especially in describing everyday decisions. Without psychology, economics lacks external consistency and intuition… Together they allow us to understand very well what and how flesh and blood people think, choose and decide in a way that no academic discipline has been able to explain on its own”, he says. Michelle Baddeley, from the Institute for Choice at the University of South Australia, in this article published on OpenMind, BBVA’s knowledge community.

Patricia Suárez , president of the Association of Financial Users of Spain (ASUFIN), explains the origin of the concepts linked to what we now call financial psychology: “ Behavioral finance —or behavioral finance— is a concept from the 1970s that began studied by psychologists Daniel Kahneman and Amos Tversky, and later developed by economists Robert Shiller and Richard Thaler , who won the Nobel Prize in Economics.

This way of studying economics taking into account the teachings of psychology — better known today as Behavioral Economics or Behavioral Economics — is not new. Adam Smith himself described in his work “Theory of Moral Sentiments” (1759) how social emotions intervene in our interactions with those around us.

But beginning in the 19th century, economists moved away from the study of behavior and based their research on the idea that people know what they want, use available information to achieve their goals, and understand the risks and benefits of their financial decisions. . In short, that making economic decisions is something rational. However, discoveries in psychology and neurology have shown that this is not the case and that we often misuse available information and misunderstand the risks we are taking.

Financial psychology, determinant in business management

Experts indicate that stress factors such as the inability to save or unforeseen economic events can be a source of health disorders. Establishing a series of financial health habits contributes positively to people’s physical well-being.

Economic psychology “aims to study how the economy, the large macroeconomic indices, influence people’s social behavior and how social behavior influences the large economic indices,” says Ismael Quintanilla , former director of the Research Unit of Economic and Consumer Psychology of the University of Valencia,

Economic decisions are largely guided by what is known as economic sentiment , adds Patricia Suárez: “What we can consider the general mood influences, which is created by macro and microeconomic indicators, but also factors of an emotional nature. , as the state of domestic economies”. The sum of millions of small personal and family decisions ultimately impact the economy in general.

The expert from the Valencian university underlines the importance of this interaction with the global economic situation: “The economy influences me and I influence the economy”. It is a model of a feedback character that fully impacts the decision-making of businessmen. Here economic psychology always has something to say: whether it is about making contracts, opening operations in new markets or drawing up adjustment plans.

Psychology influences both the making of important business management decisions, as well as those that have to do with small personal expenses and savings . Quintanilla explains that values ​​such as performance and efficient work performance, which are determined by psychological variables , both individually and collectively, have an economic impact on the company. “Accounting and everything that happens in finance has a strong psychological imprint,” she adds. Hence, financial psychology is decisive when running a company.

Suárez, for his part, points out that both in a company and in a family, decisions follow the same logic: “Growth, undertaking new projects and investing in acquiring new skills.”

The Importance of Mental Biases in Investing

One of the fields where the influence of financial psychology is most evident is in the field of investment. As in other areas of the economy, traditionally an attempt has been made to explain the behavior of financial markets based on the premise that the agents that compose it are rational. However, many financial decisions are emotional and can be influenced by feelings such as anxiety, fear of loss, over-optimism, or over-excitement.

In his work “Thinking, Fast and Slow”, Daniel Kahneman identifies two ways of thinking: the fast system, which works automatically and almost unconsciously and, consequently, requires very little energy from our brain; and slow thinking, which deals with mental activities, such as complex calculation, that require more effort. “Our brain is smarter in slow motion, but we are often guided by perceptions and emotions rather than by knowledge and deliberate thought,” explains Nuria Pesquera, Head of Behavioral Economics at BBVA.

The quick-thinking system —explains the head of behavioral economics at BBVA— makes decisions using cognitive biases and mental shortcuts that can often lead us to make mistakes.

Cognitive biases arise from the need that people have to make immediate judgments in order to respond quickly to certain stimuli or situations. On the other hand, mental shortcuts (also called heuristics) lead us to make decisions without taking into account all the information available or necessary: ​​without realizing it, we take a small part of the information and assume that we know everything necessary. “In this way, we often make the wrong decisions, we decide by eye,” explains Pesquera.

In the case of investment, some of the most common cognitive biases, according to the guide of the Spanish National Securities Market Commission (CNMV), are:

  1. Overconfidence . It is the tendency to overestimate or exaggerate a person’s ability to successfully perform a given task. The most common mistakes it causes are related to underestimating risks, not diversifying and making too many trades.
  2. Illusion of control. It refers to the tendency of individuals to think that they have the ability to influence situations on which, in reality, they have no influence. This bias can lead to a higher than appropriate level of risk being assumed.
  3. Confirmation. It consists of interpreting the information received or looking for new information that corroborates previous ideas and paying more attention to what leads us to confirm our beliefs. This error leads people to stop collecting information when the evidence gathered so far confirms opinions or prejudices that they would like to be true.
  4. Anchorage. It is the predisposition to give more weight to information obtained in the first place than to new information that contradicts it. When investing, it is common to take the past price of a share as a reference to determine its future appreciation potential. But a past price does not have to be an indicator of future appreciation potential.
  5. Loss aversion. BBVA Asset Management explains that this bias is “the tendency that people have to take a loss more into account than a gain of the same magnitude”. The main consequence of this bias is that investors tend to adopt an excessively conservative profile in order to avoid losses, which leads them to incur an opportunity cost and the possibility of not achieving their objectives. For example, by investing your money in current accounts, deposits or even in excessively conservative investment funds for the time horizon of your investment.
  6. Sunk cost fallacy. It is the bias that leads to maintaining an investment that has generated or is generating losses due to the fear of losing what has already been invested.
  7. Authority bias. It is the tendency to overestimate the opinions of certain people for the mere fact of being who they are and without subjecting them to prior judgment.