One of the recurring themes on these pages is the notion that investors shouldn’t get caught up in the daily highs and lows of the markets. Successful investing involves setting long-term goals and objectives that should be adhered to regardless of the emotions of the day.
Well, if you think this kind of advice and need for discipline in investing is something I’ve made up, think again. In fact, there are entire academic fields dedicated to studying how psychology impacts the economy, finance and investing. And what it all points to is this: how people should behave with money and investing isn’t always what they actually do. I know, that’s a shocker, isn’t it?
Studying financial behaviour
Welcome to the field of behavioural finance, which studies how people’s psychology, and specifically their biases, can affect their portfolios, as well as the economy as a whole. And there’s one specific sub-field within behavioural finance, called mental accounting, which sheds some light on how personal psychology affects financial and investing decision making.
Specifically, according to mental accounting, people attach subjective factors to the way they value money and, consequently, on the decisions they make with that money. For example, people will spend their money differently based on how it was obtained. If it was through hard work, they might be more careful in how they spend it. If they won it in the lottery, they might be more frivolous on how they spend it. History is replete with such examples.
Reason versus emotion
Yet, if one were to take a completely rational and unemotional view towards money, which all smart investors should do, there is no difference between money that is worked for and money that is won. It’s the same amount of money, and should be distributed based on factors that have nothing to do with attainment. In other words, all money is the same, but the process of mental accounting has us treating it differently.
Therefore, the conclusion to be drawn is what we’ve been preaching here for many months: Don’t let your psychological emotions get in the way of rational long-term investing. It could be the difference between reaching your investment objectives and falling short. Even the academics say so.
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