We all think and approach life differently…it’s one of the great things about being human that makes us each unique. The way my brain works, I am constantly searching for efficiencies. For me, this can happen when managing a project plan at work or deciding whether brushing my teeth or letting the dogs out in the morning is the more efficient use of time and energy. As part of this search for efficiency, I tend to think about things analytically, trying to remove emotion to make the optimal decision. No surprise, this is also how I approach personal finances. However, humans are irrational beings and a lesson I’ve had to learn is to not discount emotions in finances.
What About The Efficient Market Hypothesis?
There is a controversial investing theory called the Efficient Market Hypothesis that states the stock market takes into account all available information and always prices stocks at a fair market value. The thinking here is that it is useless trying to time the market and being a passive investor is the best approach, because stock bargains don’t exist. This is controversial because great investors like Warren Buffett have been able to consistently beat the market and, more importantly in my mind, heavily discounts humans’ irrational behavior.
Since it is humans (when not relying on AI-driven algorithm traders) that buy and sell stocks, this theory is not giving enough weight to the emotions, specifically fear and greed, that drive human decisions when stocks go up and down. The inability to effectively predict human emotions and behaviors is what leaves this hypothesis lacking.
How Do Emotions Impact Personal Finances?
The greatest financial minds have argued emotions in financial markets for decades, so how are we supposed to figure out how they impact our own personal financial decisions. The great thing about personal finance is that it is personal! We don’t need to figure out what the entire market is feeling, we just need to develop an honest understanding of our own emotions (still not easy by any means).
Sounds great, but what does this look like in practice? Below is an anecdote from a recent financial decision I was contemplating.
I was recently having a conversation with a friend about our finances and he was making an intelligent point about how to leverage debt to create passive income through investment properties. I agreed with everything he was saying and understood the logic, but had to explain to him that there was an element of emotions that he was discounting. In my life, my wife and I make financial decisions as partners, and we each have different comfort levels with financial risk. Because of this, there is an emotional factor that only my wife and I can truly take into account for our personal financial decisions. While my friend’s approach is an efficient use of funds to create passive income, would it leave us lacking if an emergency struck? Could we afford a new water heater if our old one bursts? Would we be able to afford medical bills if one of us gets hurt in our weekend-warrior hockey games? These are all factors that only I can account for, but must be part of the personal-finance calculation.
How To Account For Emotions In Personal Finances?
While it’s impossible to untrain my brain to search for the most efficient path forward, there are three primary ways in which emotions have become important factors in my personal finance decisions.
1. Understand Your Partners Emotions In Finances
When my wife (fiance at the time) first discussed comingling our finances, it was one of the most rewarding and relationship-growing conversations we had to that point in our time together. As a couple, with mutual support and dual incomes, so many of our goals and dreams felt more achievable. Over time, we’ve successfully comingled our finances, but have turned our focus to building wealth and accomplishing our financial goals. Naturally, this means deciding where to allocate our money and how to invest it. What has become clear is that our emotions and risk tolerances towards money are very different. This has prompted a lot of thoughtful conversations, forcing us to outline our priorities and build a plan that not only will help us reach our goals, but not put an undue emotional burden on us.
Professor Tip: Having an open and honest conversation with your partner about their emotional view towards finances can be rewarding and help ensure you reach your combined goals.
2. Find Your Comfort Zone With Finances
Finding your comfort zone and identifying your financial priorities is critical to your sanity and financial success. Most financial experts recommend at least 3-6 months of emergency savings prior to beginning investing. The reason for this is to make sure you can afford any unexpected expenses (medical emergencies, layoffs, etc.). By having these emergency savings, you are also protecting your emotions, lowering the constant stress of being uncertain you’re not prepared for the unknown.
While everyone should strive for an emergency fund, determining what to do with your money after that is a personal decision. Do you passively invest in a broad ETF (exchange-traded fund) and ride the market up and down? Should you take a HELOC (home equity line of credit) on your existing home to buy an investment property? Do you load up your HSA (health savings account) to protect against future healthcare costs? All of these acronyms and approaches come with varying levels of risk, so dig deep down and understand your financial comfort zone.
Professor Tip: Spend the time to reflect and determine your comfort zone with finances. This is an essential process in identifying the right investing approach.
3. Count On Emotions Being A Factor When Investing
As I’ve become a more experienced investor, emotions have just become an additional input when evaluating an investment. Often, emotions in the market are heavily influenced by news outside of the stock market. Are people able to afford their mortgages or will there be a wave of foreclosures? Is inflation running rampant and what will the fed do to address it? How are geopolitics affecting investor sentiment? Many of these inputs might seem irrelevant to investing, but we are a connected world, and all elements that make up the economy and the way we live our lives impact investing decisions. These are the emotions that drive irrational behavior in the stock market.
Professor Tip: Being current on worldly news can help you gain a better understanding of investor sentiment and can be accounted for in your investing decisions.
The Big Takeaway
With all of this in mind, my friend’s recommendation to leverage debt for passive income is a good approach that we will likely use in the future, but might be outside our comfort zone until our savings and existing home equity have grown. The efficient part of my thought process knows there is an immediate opportunity we are foregoing, but the emotional side knows that the risk of this investing approach would weigh on us emotionally and negatively impact our performance at work, marriage, and overall happiness.
At the end of the day, only you know your emotions around personal finances. Take the time to be reflective and develop an investing plan, but don’t discount emotions in finances!
Check out additional topics to make personal finance SLIGHTLY EDUCATIONAL on our Personal Finance page.
