The Question of how individuals make decisions brings about two significant but conflicting theories, the “Cognitive theory”, and the “Affect theory”. According to the Cognitive theory, people make decisions based on knowledge, analysis, and evaluations, making rational decisions. In contrast, the Affect view relies on subjective factors such as feelings, attitudes, or emotions, which could result in irrational decisions. Even though both theories are relevant in one’s decision-making phase when it comes to spending or investing, this article will focus on the affect theory and related literature that explains how emotions affect ones’ spending or investment decisions. This article will also focus on techniques individuals can employ in making sound investment decisions.
In Daubman’s view, emotions play a pivotal role in one’s investment or spending decisions. In his argument, emotions affect one’s decision in two ways; the current emotional state when making the decision and the anticipated emotions that result from making a particular decision. Another piece of literature that supports and expounds on the expected feeling is the regret theory, which captures the emotional reaction to an outcome of their investment or spending decision when one learns of another choice that would have led to a better result. Each of the three theories articulate a different angle in which emotions induce spending or investment choices.
Some scenarios that may result from emotions include Herd Instinct, Loss Aversion, and Recency bias. Herd instinct, also referred to as “herding”, involves the intuition to forgo one’s independent thought to follow other people’s decisions. In herding, emotions trigger one’s stance to make a different choice based on what others think is right. The second scenario is Risk Aversion, where investors make emotionally charged decisions when stocks or specific investments are losing value. During economic downtimes, emotions cloud one’s thinking, thus limiting their ability to make rational decisions. Another common scenario is the recency bias, where short-term market swings and volatility hinder one from remaining focused on the long term rather than the short term.
On spending, emotionally triggered expenditures could lead to losses and thus advocate taking appropriate measures that ensure rational decisions or follow the cognitive theory while spending, especially on items whose value is speculative. One of the actions
that one could take to reduce emotion-based spending is having a budget. Your budget should be consistent with your own goals and aspirations, and one should at all times aspire to stick to it unless for emergency purposes which should also be budgeted for. The second measure is figuring out one’s emotional triggers and thus avoiding them or finding ways to reduce their impact.
The last step is the practical evaluation of items based on needs or want bases. Needs tend to be basics, but wants are items that are not a necessity. Having a budget, managing your triggers, and evaluating items based on need or want are some of the critical measures that one could take in limiting emotional-based spending.
In investments, key measures that one could take in limiting the effects of emotion in their investment decisions include having a clear investment policy that outlines the objectives of your portfolio, asset allocation parameters, time horizon, and risk profile. The second measure is to have a long-term focus that is not affected by volatility and short market swings. The third measure is diversification, where an investor maintains several asset classes in his portfolio to manage risk. Last, one should cater for liquidity, where you should have cash and cash equivalent securities in your portfolio. It’s crucial to adhere to measures outlined in this article to eliminate or limit your emotions from influencing your spending or investment decisions.
Take a moment to reflect on what emotions influence your spending, and determine ways in which you can curb their influence when it is negative, and promote it when the influence is positive.
Written By:Daniel Juma
Senior Financial Advisor
Standard Investment Bank,