The psychology of fear and decision-making in investing

As Halloween approaches, you might be looking forward to enjoying some scary films or dressing up in frightening outfits.

However, while you might relish a good scare during Halloween, fear and anxiety can cause problems for your financial plan. This is because the fear response has a significant effect on your cognitive function and could cause you to make ill-advised investment decisions.

Fortunately, by understanding how anxiety and panic affects the choices you make, you could prevent any investing nightmares.

Read on to learn more about the psychology of fear and decision-making in investing.

Your body triggers a fear response when your physical, emotional, or psychological wellbeing is threatened

Fear has an important evolutionary role and, in some cases, it helps keep us alive. When you experience a perceived threat, a small cluster of neurons in the brain called the “amygdala” activates.

It sends messages to the body, releasing a flood of hormones and triggering your fight-or-flight response. You may experience a range of physical changes including:

A rush of blood to the muscles to help movement
Increased alertness caused by adrenaline
A burst of energy caused by a spike in glucose levels
Faster breathing.

In the past, this response would have made us faster and stronger, so we could defend ourselves from predators or escape from a dangerous situation. In other words, fear helped us survive.

In modern times, you’re less likely to be attacked by a wild animal, but you still experience the same biological fear response when you feel under threat.

It’s not just physical threats that cause you to feel fear, either. Your body has a similar response if you believe yourself to be in danger of psychological or emotional harm too.

For example, if you see the value of your investment portfolio fall, you might consider this a danger to your emotional and psychological wellbeing. After all, your financial plan is there to give you and your family security and allow you to live your dream lifestyle.

So, when you believe that your financial plan is under threat because of market volatility, your body might react in a similar way to if a tiger attacked you.

Unfortunately, this fear response could affect your decision-making skills.

Fear and anxiety could encourage impulsive decision-making

Psychologist Daniel Kahneman, known for his ground-breaking work on behavioural economics, identified two distinct cognitive processing systems our brains use when making decisions.

He called them “system 1” and “system 2” thinking.

System 1 is the fast, automatic, and intuitive part. It makes quick decisions without too much analysis and has an important role to play in our lives. We rely on system 1 to automatically make thousands of tiny decisions throughout the day, without causing cognitive overload.

It’s how you drive the same route to work each day without consciously thinking about every turn you need to make. System 1 is also important in an emergency because it allows us to act quickly to protect ourselves from danger.

System 2 is the rational, long-term decision-making process that we use for more complex problem-solving. You might activate system 2 if you’re looking for an alternative route to work because of a road closure.

These two modes of thinking work well together, each fulfilling an important role. Yet, in some situations, they can clash.

When you experience fear, system 1 thinking normally kicks in first because you need to act fast. If you’re under attack from a predator, you don’t have time to think logically about your response.

In some cases, such as watching a scary film, system 2 thinking will take over relatively quickly and rationalise the situation. You realise that it’s only a film and the danger isn’t real, so the fear response subsides.

However, this doesn’t always happen and when you experience heightened fear and anxiety, system 1 could remain in the driver’s seat and guide your decisions.

This is often the case during a period of market volatility. When you see the value of your investments fall, you might panic and make snap decisions because system 1 takes over.

Ultimately, this means you may decide to sell investments prematurely, change your strategy, or withdraw from the markets altogether.

Additionally, according to Psychology Today, research shows that the fear response can lead to “greater pessimism and feelings of unpredictability about the future” and also “lowers feelings of self-control”.

This could mean that you perceive a period of volatility to be more severe than it really is.

If you let fear get the better of you in this situation, you could make decisions that affect your ability to work towards your long-term goals.

We can help you avoid letting fear guide your investment decisions

Working with a financial planner could be very useful during a period of market volatility because we act as a counter to your fear response.

When you see the value of your portfolio fall, your initial reaction may be to panic. Yet, we can remind you that markets typically bounce back and you could still see long-term growth, despite a short-term dip.

More importantly, we can revisit your financial plan and demonstrate that you’re still able to achieve your financial goals, regardless of current events.

As a result, you could make more measured investment decisions based on your own unique goals and attitude to risk, rather than fear.

Get in touch

We can help you create an investment portfolio that supports your long-term financial goals.

Please contact us at hello@ardentuk.com or call or WhatsApp us on 01904 655 330. As an award-winning financial advice company with advisers included in the 2024 VouchedFor Top Rated guide, you can be sure that we’re a bona fide company providing excellent advice and high-quality service.

Please note

This article is for general information only and does not constitute advice. The information is aimed at retail clients only.

The value of your investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.

Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.