The High Cost of Emotion in Personal Finance
Our rational side knows market timing is a fool’s game. Yet, short-term trends sometimes drive our decisions.
Humans are hard-wired in ways that helped our ancestors survive over thousands of years. Investing in markets is a recent concept – the New York Stock Exchange (NYSE) was founded in 1817. Unfortunately, the cognitive processes that aided our ancestors may undermine our success in modern markets. Behavioral finance is an emerging field that examines how people use the tools of finance, rather than studying the tools themselves.
One common behavioral mistake is known as “myopic loss aversion.” Behavioralists have estimated that people hate losses roughly two-and-a-half times as much as they like gains. We exert more effort to avoid losses than to achieve gain. Suppose an investor’s portfolio rose 40% and then dropped 20%. He/she would feel the loss about 2.5 times as much as the gain. The drop causes heightened loss aversion, potentially leading the investor to panic and act against what he/she knows is rational.
Researchers measured the cost of this approach by comparing the performance of return chasing with a buy-and-hold strategy. The research reveals return chasing leaves nearly 2% on the table annually. Rather than earning 10% annually over the long term, those impaired by the recency bias took a 20% haircut and ended up with 8% annualized returns.

Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
Understanding the lessons of behavioral finance can greatly increase your odds of achieving financial freedom. Realizing that these tendencies exist is the first step in making better decisions. Remember, we hate losses roughly two-and-a-half times as much as we like gains. Fight the urge to panic over investment losses, and realize our tendency to overreact to recent history. Working with a financial adviser can help you stay on track. It’s easy to get emotional when managing your own money. An objective partner can help you overcome harmful behavior biases and remain focused on long-term goals.
Sources: Bloomberg, CFA Institute, Wall Street Journal, About Archeology, Federal Reserve Bank of St. Louis, Investment Company Institute, Morgan Stanley International
David has served as CEO of Mercer Advisors since 2008. He is responsible for the firm’s strategic vision, business plan execution, and organizational structure.
This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.
-
-
What Lawyers Often Fail to Tell Clients About Litigation
A client learns the hard way that litigation takes time and can get expensive, especially if the lawyer is piling on unethical fees and vague ‘costs.’
By H. Dennis Beaver, Esq. • Published
-
Want to Hedge Against Inflation? Consider Commercial Real Estate
Sponsored Sponsored Content from CRE Income Fund
By Sponsored • Published
-
What Lawyers Often Fail to Tell Clients About Litigation
A client learns the hard way that litigation takes time and can get expensive, especially if the lawyer is piling on unethical fees and vague ‘costs.’
By H. Dennis Beaver, Esq. • Published
-
Buying a House Could Be the Best Investment You Ever Make
Homeownership is the largest source of wealth for many. If you're facing home-buying hurdles, real estate agents who are Realtors and certified housing counselors can help you get there.
By Kenny Parcell, ABR®, AHWD, CRS, C2EX • Published
-
Finding a Balance in Financial Planning: The Tale of Two Fathers
One father spent freely and didn't save, while the other obsessed over saving. Neither flourished in retirement. Here are four steps to avoid either scenario.
By Chuck Cavanaugh • Published
-
It’s Not Too Late to Save for Retirement: Five Ways to Step It Up
You’re not alone if you feel like time is running out for you to save, but taking advantage of workplace benefits, increasing the percentage of what you save and more can help.
By Kelly LaVigne, J.D. • Published
-
How Two Tax Laws Make REITs More Tax-Friendly
Taking advantage of the return of capital (ROC) and Tax Cuts and Jobs Act rate reductions can significantly reduce the taxes on REIT distributions.
By Michael Aloi, CFP® • Published
-
We Don’t Have to Let AI Win
Just as companies and employees evolved with tech advances in the past, we can do that again with AI, but employers need to focus on preparing their workforces to keep up.
By Neale Godfrey, Financial Literacy Expert • Published
-
Five Ways to Get Key Employees to Ride Out Big Changes
Business transitions can be difficult on workers, but company owners can take steps to incentivize key employees to stick around during times of change.
By Kris Maksimovich, AIF®, CRPC®, CPFA®, CRC® • Published
-
Are You Overlooking Your Most Valuable Retirement Asset?
Selling your home and relocating could become a bigger part of the retirement conversation, given how real estate markets have boomed over the last decade.
By Julie Virta, CFP®, CFA, CTFA • Published