“People will do anything to alleviate anxiety.”
Dr. Arnold Rosen, Mad Men
With respect to the writers of Mad Men, anything may be an exaggeration, but it is an interesting point. We are living in a volatile world and many of us are experiencing feelings such as anxiety and confusion more frequently than in the past. These emotions can impact all areas of our lives, including the decisions we make. But just how much does our emotional state influence our decisions and behaviours? More specifically, how can our emotions affect our financial decisions?
Classical finance theory considers probabilities and outcomes as the key influences when making decisions. The standard practice is to assume emotionless decision making with efficient analysis of tradeoffs between alternatives. Behavioural finance, however, considers the influence emotions have on decision making.
Classical and behavioural theories are complementary as opposed to being in conflict. We use a blend of both approaches when making decisions. Business decisions, often considered an entirely rational exercise, can be improved by understanding how emotions interact with other motivations to drive our choices and behaviour – some of these emotions and their impacts are explored below.
Anticipatory emotions – emotions we experience in anticipation of a future event – can affect our decisions, as well as the speed at which we make them. Some research suggests that when we feel positive anticipatory emotions, we make decisions more quickly.
As an example, when offered the chance to invest in a project that is promoted as offering the potential for high returns, some people might feel hope and excitement in anticipation of making a profit. As a result, they might act quickly to invest without taking the time to research the project or whether this is a sound investment.
Conversely, some people might feel anxious or fearful at the thought of giving up an investment that they have held for a long time, though it no longer performs well. What if they sell off the investment, then it starts performing well again? As a result, they delay selling. In these cases, emotions override rational analysis and also affect the speed at which the decisions were made.
Visceral emotions are emotions that we feel very deeply and find it difficult to control or ignore. They operate at the subconscious level, separate from cognition and thinking, and include fear, hope, and dread. As an example, think about the panic and fear you would feel if you were charged by a grizzly bear.
Visceral emotions can have a significant effect on decision-making behavior. They can cause people to act against their self-interest with full knowledge they are doing so, and they can over-ride our cognition and thought processes.
Consider the “panic selling” that occurred in the stock market in 2008 and 2020, during which the fear of a market meltdown caused many people to sell at the “bottom” of the market and incur significant loss.
Errors in judgement often occur because individuals typically underestimate the influence of visceral factors when assessing their past, current, and future behaviour. For example, when a choice must be made, we typically underestimate the pain caused by prior similar choices. Therefore, we are more likely to choose a course of action similar to past decisions.
Projection bias and state of mind
Projection bias is a subconscious influence on decisions and relates to the role emotions have on decision making. Projection bias is a self-forecasting error, where we overestimate how much our future selves will share our current emotional state and beliefs.
This bias causes us to make short-sighted decisions since individuals disproportionately use their current emotional state to predict future states. For example, hungry shoppers buy relatively more, and make different selections, even though their future needs are equal to that of a comparable full shopper. Decisions made in a “hot” state, different than our normal state, will result in less satisfaction in the future.
Mitigating emotional impacts on financial decisions
This is not to say that emotional influences automatically lead to poor decisions. In fact, people with very low levels of emotion are less likely to conform to social norms and might experience harm as a result. Also, a lack of fear can lead to excessively risky choices.
Being self-aware of how emotions influence your decisions will enable you to assess if the influence is positive or negative and adjust appropriately. As a start, we can ask questions such as: Are the feelings I’m experiencing helpful or harmful? Are they based on facts? Are there other emotions that would be more beneficial?
Emotions are one aspect of effective decision making and taking the time to consider their impact can lead to more effective decisions.
Chris Wyman, CPA, CMA, is the vice president, learning and development at Learning Strategies Group, a company that provides tailored training services and learning solutions.