These Three Emotional Responses Could Be Costing You. Here’s What They Are and What You Can Do About It

Many of us have fallen victim to emotionally charged purchases, also known as “retail therapy.” Emotions often drive our decisions, whether for better or worse. And when they are on the negative side, these reactions might drain our bank account faster than we thought. 

According to Deloitte’s ConsumerSignals tracker, 74% of US consumers made at least one splurge to “treat themselves.” While quick indulgences might seem harmless, your spending can quickly turn into a snowball of financial consequences. 41% of people carrying credit card debt said it resulted from non-essential shopping, like luxury goods and electronics. Emotional spending, even if starting as a small amount, can fuel future possible debt.

Behavioral finance helps explain how emotions, from overconfidence to fear, influence our financial decisions. Understanding these impulses and their impact on our finances is essential to safely managing our money. Below, we discuss three behaviors that could affect your finances and strategies for approaching them. 

1. Overconfidence Bias—When You Think You Know More Than You Do

Overconfidence bias is the error in people’s overestimation of their abilities and knowledge, thus often believing that they are better at predicting outcomes. It also comes in other forms, such as an inflated sense of control, unrealistic optimism, and undermining risks. 

Overconfidence can lead to risky financial actions, such as excessive trading, under-diversification, excessive risks, and more.

Here are strategies to address overconfidence bias:

• Instead of relying on your judgment, start by seeking others’ opinions, allowing these new viewpoints to challenge your perception and prevent you from solely relying on your ideas. 
• Continually educate yourself about finances to stay current on what is happening in the market.  
• Set realistic expectations so you are prepared for any losses.
• Practice self-awareness by assessing your confidence levels and keep questioning yourself.
• Create a new approach to your finances, like systematic decision-making, that involves using qualitative and quantitative data to make decisions. 

2. Temporal Discounting—Choosing Now Over a Better Later

Temporal discounting is the tendency to favor immediate rewards over future benefits. 

People reflect this bias in their finances by spending money instead of saving for retirement, selling stocks for immediate return instead of waiting for a larger return, and more. This can sometimes lead to guilt after choosing short-term gratification. 

Here are strategies to address temporal discounting:

• Create and track your goals to focus on long-term objectives instead of gratifying the short-term. 
• Build up your tolerance by practicing delayed gratification, pushing off smaller rewards to receive larger ones later. 
• Have someone help keep you accountable, such as a financial advisor.

3. Loss Aversion and Fear—Why Avoiding Loss Can Backfire

People often perceive real or potential losses more intensely than equivalent gains, a phenomenon known as loss aversion.

This mindset can lead investors to avoid certain investments, sacrificing the potential for a gain even if it involves a risk that makes sense logically. It could also lead to panic selling and poor market timing. Ultimately, loss aversion is a sense of fear. 

Here are strategies to address loss aversion:

• Start with smaller investments and work your way up to build your confidence in lower-stakes finances. This approach helps counteract loss aversion by minimizing the fear of losing money.
• Create a trading strategy, focused on rational and prudent ways to prevent yourself from falling prey to your emotions.
• Follow a strategic asset allocation, establishing target allocations for different asset classes and often rebalancing your portfolio.

The Bottom Line

Emotional decisions are normal, but they should not control your finances. Emotions can cost you thousands when you fall for psychological biases and theories. 

Understanding your psychology and the best strategies to avoid emotional decisions can make you more confident in your financial decisions. Create long-term goals and new methods, and seek advice from others to make the best decisions. Build your emotional financial awareness.