Emotional Risk Management: emotionally driven financial choices and their impact

Inarguably, there is nothing more emotional than money. If you have it, you worry you might lose it – and if you don’t have it, you worry about getting it. Either way, the word more nearly always comes into play when we think about money.

The world of finance and investment is a complex landscape characterised by an interplay of factors. While knowledge, analysis, and strategy are crucial in making sound financial decisions, emotions often exert a powerful influence. Emotional responses to market fluctuations may lead to impulsive choices, which in turn carry significant risks for individuals and their portfolios.

Why emotions must be acknowledged and controlled

  • Emotions govern our decisions and are an intrinsic part of being human. They shape our experiences and perceptions, and financial choices are not exempt from their influence. Risk management is therefore not solely about investment tactics, but also how to handle our emotions before we make crucial choices.
  • When markets turn bearish and investments start to underperform, anxiety probably sits at the top of the emotional tree. Investors often experience a sense of urgency to take immediate action, which may not be based on rational analysis and may lead on to panic selling, locking in losses, and missing out on potential recoveries.
  • On the flip side, when things are going well and we feel we’re on a winning streak, we can become unwisely exuberant and overconfident. Becoming overly optimistic means it becomes easier to take on excessive risk, believing you can’t lose as you leap into impulsive investments and ignore warning signs.
  • Interestingly, one of the most powerful emotions is regret. Investors who have experienced losses may be hesitant to sell at a loss, hoping that their investments will bounce back. This loss aversion can lead to thoughts labelled as a “sunk cost fallacy,” where investors will continue to pour money into underperforming assets.
  • Believing what other people are doing means you consider them more knowledgeable and worth emulating. This often leads to disaster. Following the crowd rather than doing your own research is a poor recipe. This is the kind of behaviour that results in market bubbles, which give rise to significant loss when the bubbles burst.

Four steps to keeping decision-making rational and disciplined

One: Develop an investment plan with sound professional help
A well-thought-out investment plan is the foundation of rational decision-making. It’s hard to go off the rails if you have direction and goals. Working with a financial planner you can determine your investment goals, risk tolerance, and time horizon. Your financial advisor should work with you as a friend, focusing on your best options, and advising you on decisions before you leap into action.

Two: Diversify your portfolio
This is a way to keep a steady balance across a fluctuating market. Diversify across different asset classes and sectors; this reduces the risk and provides a buffer against emotional reactions to isolated events.

Three: Review and rebalance
This is another key tactic that keeps your investment refreshed and aligned with your plan; weed out asset allocations that are no longer servicing your goals, and consider new areas of investment. Working in tandem with a professional advisor, this systematic and focused approach will prevent emotional reactions to market swings and avoid impulsive decisions.

Four: Invest fixed amounts regularly
A key trick to progress patiently and sensibly is to invest a fixed amount of money at regular intervals, regardless of market conditions. This strategy reduces the impact of market volatility and takes advantage of the principle of buying more shares when prices are low and fewer when they are high.

While emotions are an integral part of human nature, they can be a double-edged sword in the world of finance. By combining emotional intelligence with a well-structured investment plan and disciplined approach, and professional support, you can navigate the emotional rollercoaster of financial choices and work toward long-term financial goals with confidence.

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Emotional Risk Management: emotionally driven financial choices and their impact