What Role Should Emotions Play in Your Money Decisions?

The field of behavioral finance tells us that as human beings, we all have emotional and cognitive biases that can lead to investment decisions that are financially irrational. So, to be successful investors, we are advised to mitigate these biases as much as humanly possible.

But our financial lives encompass more than investing, and as human beings, we are more than financial calculators. The challenge is distinguishing between emotions that cloud judgment and emotions that provide insight into what matters most. While emotional reactions should not drive financial decisions, they may provide useful information that deserves consideration.

When Emotions Cloud Judgment

Behavioral finance plays an important role in investing because it has brought to light the emotional and cognitive biases that hurt investment performance.

For example, confirmation bias may cause investors to consider only information that supports their existing views, while herding behavior may lead investors to follow the crowd rather than rely on their own analysis. These tendencies can make financial decisions feel easier in the moment, but they may also cause investors to overlook risks or make choices that are inconsistent with their long-term interests.

That is why emotional reactions should generally not be the primary driver of investment decisions.

When Emotions Can Be Helpful

Unlike behavioral finance, financial psychology considers the effects of mental and emotional factors on a person’s entire financial life. ⁽¹⁾

The usefulness of such an approach becomes obvious when someone is making a real-world decision, such as whether to pay off a mortgage. Financially, it may make sense not to, especially if the interest rate is low. But the decision may bring into consideration a range of psychological factors, including a desire for security.

Real-world decisions like this may be best framed as a trade-off among a host of factors, both financial and non-financial. In many cases, there may not be a single “right” answer. Instead, the goal is to understand the advantages and disadvantages of each option and determine which best aligns with a person’s broader goals and priorities.

Not having to make a monthly payment can bring a sense of security, but it can also reduce liquidity and financial flexibility. In situations like these, the emotional consideration is not necessarily a bias to be eliminated. Rather, it may reflect a legitimate personal priority.

Applying This to Investment Decisions

In the realm of investment advice, emotional considerations may also have a place. For example, sometimes recommendations that are technically correct may not be psychologically realistic.

An advisor could recommend an investment strategy that is financially appropriate based on a younger investor’s long-time horizon and ability to withstand market volatility. But if an investment strategy creates anxiety that makes it difficult for an investor to stay committed to the plan, the strategy may be less effective in practice than it appears on paper.

So, taking the psychological impact of an investment strategy into account, especially one that can produce a large loss, makes sense. Even heavyweights in the investment world have been known to consider the emotional impact of their own financial logic when it comes to their own portfolios. ⁽²⁾

Distinguishing Biases from Priorities

The distinction between emotional biases and emotional considerations is an important one. Emotional biases can interfere with sound judgment and should be recognized and managed. Emotional considerations, on the other hand, may help individuals better understand their goals, priorities, and tolerance for uncertainty.

The goal is not to eliminate emotions from financial decisions. The goal is to distinguish between emotions that impair judgment and emotions that reveal what matters most.

The Bottom Line

Behavioral finance provides a valuable service by helping investors recognize and avoid emotional biases that can negatively affect decision-making.

At the same time, financial decisions do not occur in a vacuum. Emotional considerations, personal values, and individual circumstances may all play a legitimate role in determining the most appropriate course of action.

Knowing how to balance financial considerations with non-financial priorities can be challenging. Discussing these considerations with your advisor can help ensure that both the financial and personal aspects of a decision are thoughtfully evaluated.

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This information is meant for educational purposes and not as direct tax or legal advice. Rules and regulations can shift anytime, so it’s always best to consult a qualified tax advisor, CPA, or attorney for guidance tailored to your specific situation.