INVESTING MONEY GUIDE

Money never starts an idea; it is the idea that starts the money

INVESTING GUIDE

:: General Investing

:: Retirement Planning

General Investing >> How Important Is Emotion In Making Investment Decisions?

It is often the heart rather than the head that rules. It was not until 2002 that the finance community really recognised the importance of emotionin making investment decisions. Back in 1979, Daniel Kahneman and his late colleague, Amos Tversky developed the "Prospect Theory" when they found that individuals were more distressed by losses than the happiness they obtained with equivalent gains.

In other words, investors fell the loss of $1 is more painful than an equivalent gain of $1. The Prospect Theory can be used to explain the risk appetite of an investor. Generally, investors are willing to undertake more risk to avoid losses then to obtain profits. In this regard, investors tend to be more risk-averse given the circumstances where they can reap profits.

On the contrary they turn into risk-takers when the possibilities of making losses are imminent. This implies that the behaviour of the individual can be shaped based on the way the information is framed. If risk-averse behaviour is desired, information should be framed in a way to encourage investors to see their options as choices among gains. Alternatively, if risky behaviour is desirable, information should be framed in a way to encourage investors to see their options as choices among losses.

As an investor, the challenge is to critically analysed the context in which the information is presented and not to fall prey to their mental biases.

<< Back to General Investing

Home | Email | Terms of Use | Add URL | Resources