Make Sound Financial Decisions by Understanding Your Reaction to Money

Jun 8, 2023

Money is a powerful and complex topic, and people’s reactions to it often stem from deeper psychological principles. Understanding how people view money, from a psychological perspective, is key to success when dealing with investments and money management. Learning how our minds interact with money can help us gain insight into why losses weigh heavier than gains, why people are so attached to losses versus gains, what time horizon factors into our risk appetite, how emotional selling works, why chasing returns is a dangerous game, and how the time in the market matters more than timing the market.

The concept of losses weighing heavier than gains is a key factor in the psychology of money. Humans experience a phenomenon known as “loss aversion”, where losses tend to hurt more than gains can please.[1] Research has shown that losses have a more pronounced emotional impact on people than gains.[2] This means that a person experiences more anguish and distress when it comes to losses than they do joy and satisfaction when it comes to gains. The reason for this, is that people are hardwired to try to avoid losses rather than attain gains.[3]

We are also more likely to be attached to losses than gains—even when they are of the same magnitude.[4] This is because losses reduce our wealth, while gains merely increase it. Losses are seen as more permanent and thus more difficult to accept than gains, which only temporarily change our wealth. Additionally, people tend to feel more regret and disappointment when they experience losses than when they experience gains.[5]

Time horizon and risk appetite are two important psychological factors when it comes to money. Time horizon refers to the amount of time a person is willing to wait for a return on an investment6, while risk appetite is the amount of risk, they are willing to take in order to achieve those returns.[7]

People with a short-term time horizon are generally more risk-averse and more focused on gains than losses. They are more likely to make decisions based on short-term wins, rather than long-term growth. On the other hand, people with a long-term time horizon are more likely to focus more on losses than gains and are more likely to make decisions based on long-term growth rather than short-term wins.[8]

Emotional selling is another important factor to understand when it comes to the psychology of money. This involves people making decisions based on their emotions rather than rational considerations. People may be tempted to chase returns and take bigger risks when they are feeling panicked, frustrated, or desperate.[9]

It is often used in the context of investments and can be a powerful way to influence a person’s decisions. By appealing to a person’s emotions, such as fear or greed, marketers can convince people to invest in something.[10]

When it comes to investing, our psychology can be even more influential. We’re faced with the decision of whether to invest for the long term or attempt to time the markets. Both of these strategies have their merits, but understanding the psychological nuances of each can help us make the right decision.

The most common advice for long-term investing is to “stay in the market”. This means to invest in stocks and other assets and hold onto them for the long-term. The idea is that, while there will be ups and downs, the markets potentially will rise over time and the investor will potentially benefit from their investment. The psychological benefit of this approach is that the investor is less likely to succumb to fear and make irrational decisions. When markets become volatile, it can be tempting to sell off investments, but a long-term approach can help the investor remain calm and rational.[11]

The idea of timing the market is to attempt to identify moments where the markets are about to rise and invest at these times. This can be done by analyzing market trends or trying to predict how the markets will move. The psychological benefit of this approach is that it can be very exciting and rewarding. The investor may feel a sense of accomplishment from successfully predicting the market’s movements.[12]

The best approach for the individual investor depends on their risk tolerance and psychology. A long-term approach may be safer, but it may not satisfy the investor’s need for risk and reward. Ultimately, the best approach is to understand one’s own psychology and make decisions accordingly. If an investor is comfortable with risk and has the patience and discipline to wait out market fluctuations, then timing the market may be a sound approach. If the investor is more risk averse, then a long-term, time-in-the-market.

Money plays an incredibly important role in our daily lives and understanding its psychological effects is key to making sound financial decisions. Money is closely linked to our emotions and can sometimes cloud judgement, leading to poor financial choices. Recognizing and understanding the emotional triggers behind decisions related to money can help us make wise and informed choices in managing our finances. The psychology of money is complex, and it is important to understand how it influences our decisions to make informed decisions with our finances.

*Disclaimer:

This article is provided by McAdam LLC dba LRVS Advisory Group for informational purposes only. Investing involves the risk of loss and investors should be prepared to bear potential losses. Past performance may not be indicative of future results and may have been impacted by events and economic conditions that will not prevail in the future. No portion of this article is to be construed as a solicitation to buy or sell a security or the provision of personalized investment, tax, or legal advice. Certain information contained in this report is derived from sources that McAdam believes to be reliable; however, the Firm does not guarantee the accuracy or timeliness of such information and assumes no liability for any resulting damages.

Any references made regarding the taxable nature of your investments should not be construed as tax advice. McAdam LLC is not a tax advisory firm; therefore, any tax decisions or assumptions should be made/verified with your tax professional.

Projected savings presented may vary depending on client longevity, and performance of assets over time.

This article is the sole opinion of this individual and is not indicative of the firm’s belief.