How behavior affects investing decisions ?

If you transfer a dollar from your right pocket to your left pocket, you are no wealthier. It is a matter of form whether a person keeps a dollar of wealth in the right pocket or in the left pocket. The form used to describe a decision problem is called a frame. Form is irrelevant to behavior. However behavior reflects frame dependence. While taking decisions we tend to form different frames in our mind and the way these frames are formed define our response to the problem.

 

Loss Aversion is a heuristic which is closely integrated with the way people behave while taking financial decisions. An example can be ‘Get evenitis’ disease or trying to get even when faced with a loss.

Faced with a choice between a guaranteed loss and a gamble to lose more or loose nothing, the investors will choose later as they hate to lose and by picking a gamble they hope to get even. Even if gamble is not risk averse; their behavior exhibits loss aversion. Two decision problems together constitute a concurrent package. Most people do not see the package. They separate the choices into mental accounts.

 

Investors prefer certain frames to other, a principal known as Hedonic Editing. People prefer guaranteed gains over gamble where they might get less – this exhibits a risk averse behavior. People also prefer gamble (with a probability to lose more or lose nothing) to guaranteed losses – this exhibits risk seeking (loss aversion) behavior. People are not uniform in their tolerance for risk, it depends on the situation. Some appear to tolerate risk more readily when they face the prospect of a loss than when they do not.

 

In case if sequential investing, people have tendency not to net their two gains (of two separate and sequential transactions) but to net losses. The added attraction of experiencing gains separately inclines people to be more willing to gamble. The term frame dependence means that the way people behave depend on the way their decisions problems are framed. Hedonic editing means that they prefer some frames to others. In a financial context, hedonic editing offers some insight into investor’s preference for cash dividends. When stock prices go up, Dividends can be savored separately from capital gains. When stock prices go down, dividends serve as a silver lining to buffer a capital loss. This is frame dependence; investors feel comfortable choosing a portfolio of stocks that feature high payouts and spending those dividends