CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 72% of retail investor accounts lose money when trading CFDs with this provider (Saxo Bank). You should consider whether you understand how CFDs, FX or any of our other products work and whether you can afford to take the high risk of losing your money.

Investment Behaviour – Understanding Weber’s Law & Loss Aversion

Investment Behaviour finance draws heavily on:

We would suggest that a majority of people would have some psychological bias.

a) Mental accounting refers to the treatment we accord to different “accounts” hence we are more liberal with spending £100 of holiday money than £100 in an ISA.

We attribute spending and investing decisions according to how we categorise the money i.e. we are more willing to spend a lottery windfall than payroll income because we view funds with varying degrees of merit, even though the source of the money should be irrelevant to the decision as to whether or not to spend it.

We are more willing to gamble with a lottery windfall; i.e. the illusion of the gambler’s “lucky streak”. This works in reverse as the “snake bite” effect. After taking a loss an investor will reduce position size and be less inclined to take risks. People react to their profit & loss account.

Mental accounting also categorises expenses. Credit card pounds are “cheaper” than cash in the bank because you can defer payment, what is known as the “never never” at least in the short term. In fact, the APR’s charged on credit cards make using plastic far more expensive than a debit card.

Solutions for mental accounting issues include; i) waiting before spending windfalls ii) imagine all income is “earned” income iii) imagine a world without credit, “how much would you pay in cold hard cash?”

b) “Prospect theory” – how do we emotionally treat gains and losses?

Are we more distressed by prospective losses than we are happy by equivalent gains? If so then we will take more risks to avoid losses than to monetize gains.

According to Gerald Butrimovitz, “the pain of loss is 2.5x stronger than the joy of gains”. This is because investors are emotionally motivated by whether the sale transaction will generate a profit or loss.

Studies show the pain of a loss is twice as great as the pleasure of a gain

 

To understand Weber’s Law & Loss Aversion model in greater depth, simply click this link for a further description.

A loss can cause embarrassment when it is reported to third parties hence contributing to a tendency to avoid selling losers.

This approach explains “herd mentality”, the relative safety of “following the crowd” so that if individual decisions prove incorrect the decision maker has the defence of saying that everyone else was making the same decision. This is often a costly approach, as the adverse price movement may be due to a change in the business.

The “disposition effect” is related to loss aversion, in that portfolio decisions are made on the basis of the profit/loss account and not the merits of the underlying business, the portfolio’s diversification benefits or other long-term considerations.

Example; you have a 2 stock portfolio comprising BP (+20%) and Marks & Spencer (-20%) but no cash. You want to buy Vodafone but you will need to sell either BP or Marks. The disposition effect predicts you will sell BP as the sale will trigger “pride” and avoid the “regret” of triggering a loss.

The disposition effect is particularly abundant in male thought process/ decision making which requires ego boosting periodic rewards/ “pats on the back”.

Obviously, such an approach does not have a basis in the relative investment merits of BP or Marks & Spencer.

But arguably that should be a major factor in decision making.


Part 3 will be published on , get ready to learn how to manage your mindset to create a focused, clear and profitable solution to understanding your behaviour. 

If you’re new to the CSS Investments blog, please make sure you read our introduction post here to find out how this blog will help you become a better informed investor or trader.

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