Psychology of Money

Behavioral characteristics influencing financial decision making

Risk tolerance

Risk is a fundamental characteristic of investment options and investor decision-making. Consequently, risk tolerance is one of the most important behavioral characteristics of investors. Effectively matching risk tolerance to financial portfolios is critical to successful money management. And studies have shown while there can be small short-term swings, for most investors, tolerance for risk stays remarkably constant throughout their investing life. Unfortunately, risk tolerance is often misjudged, as most tools (i.e., the investment policy statement) used to measure it are not well-suited to capturing an investors “true” attitudes towards financial risk.

Loss aversion

Behavioral finance studies have shown repeatedly that for most investors, the pain of losing money is greater than the pleasure of winning money. This means that while a person can be “risk seeking” when pursuing financial gains, she can also be “risk averse” when it comes to incurring losses. Loss aversion is an important trait for financial advisors (and their clients) to recognize, as it can have significant consequences for financial planning. For an investor with extreme loss aversion, preventing major losses is a major consideration.

Cognitive impairment

As we age, significant behavioral changes can often occur. The most serious changes are those that affect our cognitive capabilities. Cognitive decline can start as early as age 60, after which the frequency of cognitive impairment doubles roughly every 5 years. It has been estimated that roughly half of all people in their mid-eighties has some form of cognitive impairment. Cognitive impairment can manifest itself in everything from memory loss to spatial/temporal disorientation to speaking difficulties and mood disorders. Consequently, cognitive impairment can have devastating consequences for financial decision-making. Even worse, the decline in cognitive impairment occurs during the time when most people are responsible for managing more money than they have ever had in their lifetime.

Over-confidence

It is perhaps inherent in the human condition that many of us remain confident in our physical and mental capabilities long after they have peaked. While this propensity can at time be harmless (like when a father loses a game of one-on-one basketball to a son or daughter), over-confidence in one's financial literacy can have deleterious consequences for financial decision-making. A recent study found that actual levels of numeracy and financial literacy decline much faster than perceived levels, resulting in overconfidence. The study authors conclude that overconfidence in one’s financial knowledge is a significant predictor of the odds of falling victim to a financial scam.>/p>

Gullibility

For many years, psychiatrists have observed that elderly people tend to be more trusting of strangers than younger people. A recent study helps to explain why. Neurological researchers have now identified the area in the human brain where they believe doubt arises. Damage to this region of the brain is associated with lower levels of doubt and higher levels of trust. The findings of this study help to explain why seniors are more prone to fall victim to deception and financial abuse.

Emotional stress

Emotional trauma – which can result from the death of a loved one, a major illness, or a move to a new location – has been shown to have negative consequences for decision-making. Seniors who have recently experienced a traumatic emotional event may be more likely to make poor financial decisions. Because they are emotionally vulnerable, they are also more likely to be victimized by a financial scammer posing as someone trying to help.