The Theory of Investing money

People may go out of their way to save Rs 5 on purchase of goods worth Rs 25, but won’t go to the same trouble to save Rs 5 on purchase of a CD worth Rs 500. Change in wealth appears to be more important than the ultimate value.
Amos Tversky and Daniel Kahneman found that people are willing to take more risks to avoid losses than to realise gains. People tend to ignore ‘sunk costs’ and dislike accepting losses. A familiar problem with investments is the sunk cost effect — the tendency to ‘throw good money after bad’. People have such a dislike for incurring losses that many are willing to accept gambles in the hope of avoiding them. Imagine that someone had bought shares of ‘XTech’ before the tech bubble burst in ’00. The market price is now a lot lower than the price paid and the investor is facing a significant paper loss. But he/she is unlikely to sell the shares because that will involve ‘crystallising’ the loss. The past is irrelevant; all that matters is the future.
The key question is: which investment offers the best potential for gains? If the answer isn’t XTech shares, they should have been sold, and what’s left of the investment should be swept into the best options available. The status-quo bias is another trap. A study conducted by William Samuelson and Richard Zeckhauser provides an insight into our reluctance to change when dealing with financial issues.

A group of students were asked how they would invest a hypothetical large inheritance. Half of them received their inheritance in low-risk bonds and the rest received higher-risk securities. Common sense suggests that individuals will reassess their asset allocation based on their risk profile and timeframes, but both groups chose to leave most of their money alone. Students’ fear of switching into securities that may end up losing value prevented them from rebalancing their portfolios.
Herding instinct is another bias. Human beings are social creatures and draw comfort from being in a group. Due to ‘irrational exuberance’, investors invest large sums of money in select sectors/ stocks, without paying heed to one’s asset allocation and risk tolerance. This leads to buying of securities at near-peak prices and selling of securities in a downturn. Success in the investment world depends on the decisions one makes. But people tend to get carried away by the moment and end up making bad decisions.
Behavioural economics does not suggest that human beings are irrational; it indicates that not all our actions are rational because the human mind has limited capacity to store and process information. We rely on simple thumb rules (or ‘heuristics’) which serve us well, but lead us into consistent errors. Success in investing lies in being aware about these pitfalls and trying to overcome them. In other words, keep emotions out of investing.