Psychology plays an important role in investment. Many people (including seasoned investors) don't realise the influence psychology has on an investor's decision making. Below, we introduce two concepts that are not only interesting, but also useful in helping you avoid making bad investment decisions:
Here's an interesting experiment: Given a choice between 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? If you're like most people, you would've chosen the second option (i.e. option B) in the first question, and the first option (i.e. option A) in the second. 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-out" on investments that they've profited from.
Mental Accounting refers to investors' tendencies to mentally place goals into different "categories". They then assign different portions of their wealth to meet the different goals. For example, suppose you intend to make two large purchases - a computer and a TV. Instead of assessing your total wealth and deciding on whether it makes sense to make any of the purchases, people with mental accounting would split their wealth and dedicate money to each "goal". It is like having two separate savings jars labeled "Computer" and "TV" each, and only making a purchase when one of the jars has accumulated enough money for the item. Mental accounting generally leads to poor allocation of investment funds, however, it is a good way to instill self-control and discipline. For example, by "tricking" yourself to put away a certain amount of your savings in order to achieve a certain goal (e.g. paying off your credit card debt / mortgage, saving for children's education), you are less likely to spend the money and more likely to reach that goal.