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6 Investing: Definitions and Emotional Challenges*

Learning Outcomes:

  • Define an investment.
  • Explain the difference between stocks and bonds.
  • Compare and contrast investing and saving.
  • Understand the mechanics of investing.
  • Comprehend the impact of emotions on investment decisions.
  • Understand the importance of investing as early as possible.
  • Learn how investing early pays off over time.

stacks of coins with a plant atop growing in size with the last in a jar with the largest plant

Investing*

Before looking at investment planning and strategy, it is important to take a closer look at the galaxy of investments and markets where investing takes place. Understanding how markets work, how different investments work, and how different investors can use investments is critical to understanding how to begin to plan your investment goals and strategies.

You have looked at savings plans and ways to create surplus cash. Investing is primarily about using the capital markets to invest that surplus cash for the longer term. The capital markets developed as a way for buyers to buy liquidity. In Western Europe, where many of our ideas of modern finance began, those early buyers were usually monarchs or members of the nobility raising capital to finance armies and navies to conquer or defend territories or resources. Many devices and markets were used to raise capital, but the two primary methods that have evolved into modern times are the bond and stock markets. For a thorough history of the evolution of finance and financial instruments, see Charles P. Kindleberger’s A Financial History of Western Europe (1984).

In the United States, 47 percent of the adult population owns stocks or bonds, most through retirement accounts (Sabelhaus et al., 2008, p. 1).

Get To Know Investment Terms

Play FINRA’s Learning to Invest Game so that you become more familiar with investment terms.

How Does Investing Differ from Saving?

Watch the video:

In this activity, students will:

  • Understand the differences between saving and investing.
  • Explore the different goals saving and investing can help achieve.

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How Does Investing Work?

stock numbers and arrow slowly moving to the right and up

Watch the video:

In this activity, students will:

  • Calculate capital gains and capital losses for stock transactions in terms of dollars and percentages.
  • Understand how these calculations can help evaluate a stock’s past performance.

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For Building Wealth

students from various backgrounds listening to a presentation

In this activity, students will:
  • Use an online calculator to discover how investments grow over time.
  • Identify reasons to start investing as early in life as possible.

Emotions and Investing

When making decisions on investing, it is important not to let your emotions determine your investment decisions. Emotions can lead us to make irrational decisions. For example, when it comes to investing, emotions can lead us to buy investments at high prices and then sell them at low prices. By understanding how emotions impair decision-making, you can help limit the negative impacts on your long-term financial plans. Thinking in the short term, we may overlook the future rewards of an investment, but rather see only the immediate benefits. Thinking in the short term, we may also fear losses more than we value gains. This is called loss aversion. It is important not to overreact when the market takes a downswing, but rather understand that it will undoubtedly bounce back. To avoid the negative impact of emotions on our decision-making,  plan ahead. Seek a financial advisor who can help you identify the emotions you bring to your financial decision-making. Always keep an eye on the long-term goals that investing will bring to you. (Emotions and Investing, n.d.)

Watch the video:

 

Here are some of the biggest emotions that influence financial decisions:

  1. Fear is perhaps the most powerful emotion when we make financial decisions. It can dissuade you from investing money in the stock market or lead you to pull money out of the stock market at the first sign of a downturn in market prices.
  2. Greed may lead you to take excessive risks in your pursuit of wealth. It can make you overlook any downsides or risks, focusing only on the potential upsides.
  3. Anxiety and depression often lead to poor decision-making when it comes to personal finances.

(Alberhasky, 2024)

 

There are also some biases that drive investor behavior:

  1. Anchoring bias is the impulse to rely on the first piece of information when making judgments. Rather than looking for similar stocks at a better price, you select too quickly and proceed.
  2. Herd mentality is following the crowd, selecting investments based solely on what everyone else is doing.
  3. FOMO (fear of missing out) is the bias of perceiving items or opportunities as more valuable simply because they are scarce or rare, regardless of their true worth.
  4. Confirmation bias seeks to find only information that validates your investing opinion rather than looking for alternate opinions.
  5. Familiarity bias leads you to make investment decisions based solely on industries and assets that you know well.
  6. Loss aversion, where the fear of losing money is stronger than the satisfaction of earning money, may lead you to miss out on investment opportunities.
  7. Overconfidence may result in making riskier investments, in the belief that you will always generate higher returns than market indexes.

(Guberti, 2023)

 

Before making financial decisions, here are some questions to ask yourself:

  1. Is this an emotional or logical decision?
  2. Are my emotions causing me to be too cautious and miss out on a good opportunity?
  3. Are my emotions causing me to be too excited and overlook the risks of a given opportunity?
  4. Is decision paralysis making an unpleasant situation even worse?

(Alberhasky, 2024)

Key Takeaways:
  • Saving to build wealth is investing.
  • Investing happens over your lifetime.
  • Stocks are a type of investment that gives people a share of ownership in a company.
  • Stocks offer investors the greatest potential for growth (capital appreciation) over the long haul.
  • When you sell a stock for more than you paid for it, that’s called a capital gain. When you sell a stock for less than you paid for it, that’s a capital loss.
  • By understanding how emotions impairs decision-making, you can help limit the negative impacts on your long-term financial plans.
  • Investors who hold on to an investment for the long term tend to come out ahead.

 

* The introduction to this section was adapted from Sect. 12.1 of Individual finance, by R. S. Siegel and C. Yacht, under a Creative Commons CC BY-NC 3.0 Unported License.

Please Provide Feedback

What is one tip that you learned from this chapter?

References

Alberhasky, M. (2024, March 25). How emotions impact your financial decisions. Psychology Today. https://www.psychologytoday.com/us/blog/psychology-money-and-happiness/202403/how-emotions-impact-your-financial-decisions

Emotions and Investing. (n.d.). Commercial Trust Company. https://www.commercebank.com/sharedcontent/pdfs/trust/featured/emotions-and-investing.pdf

Guberti, M. (2023, October 27). Behavioral finance: FOMO, loss aversion and other investing biases. U.S. News & World Report. https://money.usnews.com/investing/articles/behavioral-finance-fomo-loss-aversion-and-other-investing-biases

Kindleberger, C. P. (1984). A Financial history of Western Europe. Allen & Unwin.

Sabelhaus, J., Bogdan, M., & Schrass, D. (2008). Equity and bond ownership in America, 2008. Investment Company Institute [ICI] and Securities Industry and Financial Markets Association [SIFMA]. http://www.ici.org/pdf/rpt_08_equity_owners.pdf

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Investing: Definitions and Emotional Challenges* Copyright © by Edited is licensed under a Creative Commons Attribution 4.0 International License, except where otherwise noted.

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