Why the reluctance?

To explain investors’ behaviour, one will have to turn to the discipline of behavioural economics. In 1979, psychologists Daniel Kahneman and Amos Tversky suggested that the pain people feel when they sustain a loss surpasses the pleasure they feel when they make a gain of the same magnitude. It is estimated that the pain tends to be two-and-a-half times as intense as the pleasure.

Investors’ current loss aversion can also be explained by the fact that we humans don’t handle reversals in the direction of the market too well. As investors we tend to believe that the future will be a continuation of past trends.

It is this belief that engenders market booms. As markets rise and investors make money in them, their confidence level soars in tandem. They then begin to perceive lower risk in equities, even though a rational evaluation would suggest that as valuations rise higher the downside risk increases. What also comes into play is the phenomenon called the “house money effect”. Gamblers, after they have won some money in the initial rounds, are prepared to place bigger bets, their logic being that they are not betting their own money but what they have won at the table. A similar psychology operates in the markets, prompting investors to place riskier bets.

The opposite effect comes into play after investors have lost money. Their risk aversion rises much higher than usual. They then refuse to invest in opportunities which in the normal course of events they would have bet on willingly.

... contd.