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Logic goes out the window

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Human beings are affected by a myriad of social, psychological and emotional factors which often make them behave irrationally and illogically.

Behavioural finance tries to explain why and how investors make suboptimal decisions, which create anomalies, such as during stock market bubbles and crashes.

By understanding the cause of irrational behaviour, investment returns can hopefully be improved. Losses are more painful than gains, so investors prefer to lock into a guaranteed modest gain and avoid a sure loss.

In a series of 1980s articles by Amos Tversky and Daniel Kahneman, 150 people were asked to make two decisions: The first was to choose between (a) a sure gain of S$240 (HK$1,485) or (b) a 25 per cent chance of gaining $1,000.

Or second: to choose between (c) a sure loss of $740 or (d) 75 per cent chance of losing $1,000.

The result was that 84 per cent and 87 per cent of the respondents chose (a) and (d), respectively, even though (b) and (c) would result in higher expected values (i.e the gain or loss multiplied by the respective probability).

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