The science of economics has long been based on the assumption that people act rationally when making financial decisions. Money and math require cognitive thinking, so it’s presumed that rational thinking is what people use when deciding whether to buy or sell, borrow or lend, or choose the right account for their savings.
If emotions do enter into the picture, economists argue that they should be minimized in an effort to restore rational thought. Under orthodox Keynesian economics, emotions disturb rationality.
Even behavioral finance pioneers Amon Tversky and Daniel Kahneman focused on how people think when making financial decisions. Their seminal 1979 paper “Prospect Theory: An Analysis of Decision Under Risk” revealed that people don’t always make rational choices when evaluating potential gains or losses. But these errors in judgement were considered cognitive biases related to how people frame an outcome or transaction in their minds, not the influence of emotion.
Although Tversky and Kahneman came from the field of psychology, they essentially ignored the role of emotions and interpreted all deviations from rational thought as faulty thinking.
More recently, neuroscience has converged with economics and psychology to shed new light on what is going on in people’s brains when they make financial decisions.
If financial decision-making were purely a cognitive process, all thinking would take place in the prefrontal cortex, and this is the only area that would light up during an MRI scan. But studies have shown that activity also takes place in the amygdale, or brain stem, proving that emotion plays a part in people’s decision-making as well.
The Upside of Emotion Decision-Making
Emotion, when related to financial decision-making, is normally considered a bad thing. It’s widely assumed that fear and greed lead to bad investment decisions, that grief following the death of a loved one causes cloudy thinking, and that euphoria following a lottery win or other windfall makes people do stupid things with their money.
But some researchers have proposed that emotions, which protect us under threatening circumstances (think fight or flight), may also have a positive influence when we are engaging in higher-level thought.
For one, emotions might push a person to make some decision – any decision – when doing so is paramount. Depending on the situation, there could be so many options that a person could spend an excessive amount of time sifting through the data, weighing all the choices, and becoming bogged down in an attempt to be rational. Shifting one’s attention to the expected emotion, or how one might feel when anticipating an outcome, might allow the person to cut through the details and focus on what’s important… getting on with the decision.
Second, emotion may be necessary for the development of intuition in situations where quick decisions must be made using information that has been synthesized on a subconscious level.
A study of professional securities traders hooked up to an EKG and skin conductance devices during the trading session found that, far from being completely rational in their thought processes, the most successful traders were having emotional experiences as well.
The researchers concluded that emotion enables traders to form intuitive trading “rules” that give them an edge in the markets and in fact leads to a kind of “survival of the fittest” in the trading environment. By this interpretation, emotion is not something to be minimized or ignored but rather embraced and understood, almost as an evolutionary mandate.
Elaine Floyd, CFP, is Director of Retirement and Life Planning for Horsesmouth, LLC.
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