Why Emotions and Money Don't Mix

Emotions can play a major role in how you handle money, and lead you to make decisions you may regret. Fear, for instance, can push you to sell investments too soon, while greed or overconfidence might steer you towards risky bets. Understanding the basics of investor psychology – including behavioral biases and cognitive biases in finance – can help you make smarter, more balanced choices. And the more aware you are of these emotional traps, the better you can stick to a solid financial plan and build long-term wealth.

Quick facts:

• Emotions can impact financial decisions more than logic and reason do.
• Cognitive biases refer to systematic errors in thinking that affect how you interpret information and make decisions.
• Behavioral biases include cognitive biases but also incorporate emotional and social influences on decision-making.
• Biases include loss aversion, overconfidence, herd mentality, confirmation and anchoring.

Understanding behavioral and cognitive biases in finance

In the context of money and investing, behavioral biases are psychological tendencies that lead to irrational or emotionally driven financial decisions. These biases, such as loss aversion, overconfidence and herd mentality, can cause you to overreact, misjudge risks or make impulsive choices.

Cognitive biases, on the other hand, are rooted in mental shortcuts that help us process information quickly, making decisions based on limited information and preconceived notions. While those may seem like time savers at first glance, these biases can lead to errors, like focusing on a stock's previous price to make investment decisions.

Common biases that impact financial decisions

Here’s a quick look at some common behavioral and cognitive biases that can affect investors.

Loss aversion

Research shows the fear of losing $100 is significantly stronger in magnitude than the excitement of winning $100 – a concept called loss aversion.¹ This bias can prompt you to make decisions that avoid losses rather than seek gains, such as holding onto losing investments for too long, selling winners too soon, avoiding risky but profitable opportunities and overreacting to market volatility.

Overconfidence bias

Overconfidence bias is the tendency to be more optimistic about your skills, talent or intellect than facts justify, such as believing you're an expert skier when you belong on the bunny hill. For investors, overconfidence bias can make you overestimate your knowledge of the financial markets, leading to excessive trading, underestimating risks and trying to time the market.

Herd mentality

The fear of missing out (FOMO) is a key driver of the herd mentality behavioral bias. In investing, it happens when you follow the crowd instead of making independent decisions based on facts (e.g., fundamental analysis, professional advice). By buying and selling investments based on hype or fear rather than solid research, you risk getting caught in market bubbles or panic-driven selloffs, which can lead to poor investment outcomes.

Confirmation bias

Confirmation bias happens when you only pay attention to information that supports your existing beliefs while ignoring anything that contradicts them. For example, you may think a stock will go up, so you focus on good news and dismiss warning signs. This bias can lead to poor investment decisions, as you may overlook risks and fail to adjust your strategy based on objective data.  

Anchoring bias

Anchoring bias happens when you rely too heavily on initial numbers or impressions when making decisions. Markets are dynamic, so focusing on outdated data points can lead to faulty investment decisions. For example, say you bought a stock at $100 that's now trading at $70. You might cling to the losing investment, refusing to sell it for less than you paid due to your emotional attachment (i.e., an "anchor") to the purchase price.

The risks of emotional decision-making

Emotional decision making can lead to impulsive choices, causing you to react based on fear or excitement rather than logic.

Market volatility and emotional reactions

Fear and panic can cause you to make rushed investment decisions that hurt your long-term success, especially during periods of market volatility. For example, when the market drops, you might panic and sell at a loss, locking in losses instead of waiting for the market to recover. Fear can also stop you from investing at all, making you miss opportunities for growth.

To maintain a long-term perspective and avoid fear-driven investment decisions, consider these strategies:

• Stick to a plan: Create an investment strategy based on your goals and risk tolerance and follow it regardless of short-term market swings.
• Diversify your portfolio: Spread investments across different assets to lower risk and balance overall returns.
• Focus on fundamentals: Make decisions based on company performance, financials and long-term potential rather than daily price movements.
• Use dollar-cost averaging: Invest a fixed amount regularly to smooth out market fluctuations and eliminate the stress of trying to time the market.
• Think long-term: Remember that market fluctuations are normal, and historically, staying invested for the long run leads to growth. Time in the market, not timing, matters most.
• Seek professional advice: A financial advisor can provide guidance and help keep your emotions in check.

Impulse spending vs. rational budgeting

Impulse spending happens when you make unplanned and spontaneous purchases that don't fit your budget. Emotions – from anxiety and stress to happiness and excitement – can trigger impulse spending. While a single impulse purchase may seem harmless, frequent overspending can easily lead to negative consequences, such as:

• Financial stress: Overspending can strain your budget, making it harder to pay for essentials.
• Debt accumulation: Frequent impulse purchases, especially on credit, can lead to high-interest debt.
• Regret and guilt: Buying things on impulse often leads to regret, especially if the purchase wasn't needed.
• Missed financial goals: Money spent impulsively could have been saved or invested for long-term goals.
• Clutter: Unneeded purchases can fill your home and workspace with clutter, which can negatively impact your mental health and well-being.
• Emotional dependence: Using shopping to cope with emotions can become a habit, reinforcing unhealthy spending behaviors.

Financial planning and self-discipline can help you avoid impulse purchases and stay in control of your money. A good plan sets clear goals and lets you focus on what you need, while self-discipline helps you stick to your budget and avoid making emotional purchases. Together, they can help you save money, avoid debt and work toward a secure financial future.

Real-world examples of emotional financial decisions leading to losses

The 2008 financial crisis

The 2008 financial crisis was spurred by multiple factors, including a housing bubble, risky mortgage lending and inadequate regulation. The collapse of Lehman Brothers triggered panic throughout the U.S. and global financial systems, resulting in one of the most severe financial crises in the nation's history.²

Former Federal Reserve chairman Ben S. Bernanke wrote in a 2018 paper, "Panics emerge when news leads investors to believe that the 'safe' short-term assets they have been holding may not, in fact, be entirely safe."³ As investors lost confidence in the financial system and the solvency of major financial institutions, they quickly got out of the stock market. As more investors followed the herd, a massive selloff drove stock prices even lower, amplifying losses.

Cryptocurrency and market speculation

Emotional investing plays a major role in speculative assets like bitcoin and meme stocks, often driving extreme volatility and unsustainable price movements. For example, FOMO and the herd mentality bias can lead to rapid price swings, often fueled by social media, such as the r/WallStreetBets subreddit that drove GameStop's (GME) stock to extreme highs in 2021.⁴

Similarly, cryptocurrencies like bitcoin experience "boom and bust" cycles where investors flock to the assets (a move made due to FOMO, herd mentality and greed) and then flee as fear, uncertainty and doubt take over.

Strategies to reduce emotional influence on financial decisions

Develop a long-term financial plan

Developing a long-term financial plan can help reduce emotional decision making by providing structure and discipline. Here are a few tips for creating one:

• Set goals: Decide what you want to achieve (such as buying a home, retiring comfortably or paying off debt), then write it down to help you stay focused when emotions kick in.
• Make a budget: Track your income and expenses to stay in control of your spending.
• Build an emergency fund: Aim to save three to six months' worth of expenses to handle surprises without stress.
• Diversify your investments: Spread your money across different types of investments to reduce risk.
• Automate savings and investments: Set up automatic transfers to stay consistent.
• Review and adjust: Revisit your plan annually or as life circumstances change.

Practice mindfulness in financial decision making

Being mindful can help you stay calm and make rational choices instead of reacting emotionally. Here are some tips:

• Tap the breaks: Take time to reflect before making important decisions.
• Identify emotions: Recognize feelings such as fear, excitement and stress that could cloud your judgment.
• Practice gratitude: Appreciating what you have can help reduce impulse spending.
• Breathe and stay calm: Deep breaths can help calm anxiety and bring clarity before making financial decisions.
• Seek a second opinion: Talk to someone you trust for an outside perspective.

Seek professional guidance

Many investors struggle to make informed, rational investment decisions on their own. A financial advisor can help you avoid emotional and cognitive biases by providing objective, data-driven guidance to keep your emotions in check, helping you stay on track for long-term financial success.

Bottom line

Behavioral and cognitive biases affect your financial decisions, and not usually for the better. A patient, rational approach to money management can help you make smart, informed financial decisions without being driven (and potentially dragged down) by emotions. By focusing on facts, long-term goals and data-driven strategies, you can lower risks while steadily growing your wealth. Navigating emotional traps can be tricky. Consider working with a financial advisor who can help keep your emotions in check.

Investment advisory and financial planning services offered through Summit Financial, LLC, an SEC Registered Investment Adviser, doing business as Conway Wealth Group (4 Campus Drive, Parsippany NJ 07054. Tel. 973-285-3600). Neither Summit Financial nor Conway Wealth Group provide tax or legal advice. 7785024.1

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1. Psychology Today, “How Emotions Impact Your Financial Decisions. (March 2024)
2. Federal Deposit Insurance Corporation (FDIC), “Origins of the Crisis.”
3. Brookings Institution, “Financial Panic and Credit Disruptions in the 2007-2009 Crisis.” (September 2018)
4. Cato Institute, “The GameStop Episode: What Happened and What Does it Mean?” (Fall 2021)

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