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    Thursday, September 17, 2015

    Financial Decisions and Emotions


    In a recent lecture on the role of emotions in financial decisions that I gave to financial advisors in a  large investment bank I heard many in my audience complaining about their clients. Most of them agreed that it is becoming harder and harder to understand their clients' risk attitude, their expectations and even the horizon they wish to invest for. When bugged with questions, they say, client's would often respond by saying: "What do I know? You are the expert!"

    In today's world, where most doctors relegate tough medical decisions to their patients, including the decision of whether to take treatment when suffering from terminal cancer, and where most patients cooperate with this policy, investors are still reluctant to take more responsibility for their own finances — as if money is way more important than life and death. The conventional wisdom about such behavior emphasizes complexity: investment decisions are complex and people have "limited cognition."

    But are they really more complex than medical decisions? Do investment advisors request their clients to perform mean-variance analysis? In the last two decades "simplicity" became the magic word of financial engineering. Make financial information accessible and simple for investors and they will take responsibility. But this doesn't seem to work.  This doesn't work because the problem is not with the input of financial decision making but rather with the output. It's is not that investors lack information or intelligence upon which to decide but rather that they simply don't want to decide, or put more correctly, they want other people to decide for them.  The impediment for making financial decisions is not cognitive but emotional. At the center of this emotional obstacle lies regret and the fear of regret.
    Source: flicker

    A full corpus of research papers in psychology and behavioral economics documents the phenomenon. People are often reluctant to take decisions if they expect that they might regret them. One might ask why regret plays much smaller role in medical decisions? The answer is that in order to experience regret we need to know the counterfactuals. We need to be able to reason in retrospect about what would have happened had we taken a different action.  It is almost impossible to do it when we make decisions about our health. If we decided for treatment A against a certain disease we would know how well we do with it but we would never know how well we would have done with  treatment B. It is very different with financial decisions. If we decide in favor of stocks and against bonds we would not be able to avoid reporting to ourselves in the future whether we made the right decision — after all a simple internet click will reveal all possible counterfactuals within seconds.  Apparently this is pretty intimidating!

    If this all makes sense does it also mean that we should give up on investors? on ourselves?

    Does it mean that there is  little scope left to making people more responsible in their finances? Not at all! but I will leave the "how" for a later post.

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     This topic brought to you from psychologytoday.com
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