Psychology: Inside An Investor’s Mind

Woman with question marks because of psychology of investmentPsychology plays a significant role when making investments. That is why all investors should realize its importance and influence in decision making processes when investing. Here are two interesting concepts related to psychology that could be of great help when making investment decisions.

Aversion to Loss

Loss aversion is a popular phenomenon. It could be a significant trap in investing. It is a behavior that drives investors to simply avoid losses.

Pick one:

A) a small loss, and
B) a 50-50 chance of either a large loss or breaking even

Which would you choose?

Here’s another question: Assuming instead of a loss, it’s between

A) a small gain, and
b) a 50-50 chance of either a large gain or breaking even

Now this time, which would you prefer? Most would choose option B.

This preference for “certain gain” and “uncertain losses” is common among investors, and explains why some investors “double down” on investments where they’ve experienced losses, and quick to sell investments that they have made a small profit from, despite a greater potential for gains.

Mental accounting for losses

If you tend to put goals into various categories, you are doing mental accounting. You may assign different portions of your resources to meet your varied goals. For instance, if you plan to buy either a TV set or a computer, you may decide to purchase both without assessing your capacity to buy. Thus, you may allocate two types of savings to cover both and finally make a purchase when one of those accumulates the required amount to purchase.

Thus, mental accounting should be avoided because it results in poor allocation of funds for investment. On the upside, it can be effective in instilling discipline and self control when it comes to personal finance. By setting a goal when saving money to achieve a specific goal, you could be more determined to save just to attain that.

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