The mind over money: How psychology shapes your financial fate

April 11, 2026April 14, 2026 admin 0 Comments behavioural finance, financial planning, INVESTING, money habits, personal finance, psychology, Risk management

People’s lives are forever controlled by Greed and Fear.” — Robert Kiyosaki”

You know what B2B is?

Yes, it is “Business to Business.” But in stock market circles, B2B carries a different, almost ironic meaning— “Bhav to Bhav.” This describes the investors who buy a stock at a certain price (bhav) and will not sell if it declines, even if they have to wait weeks or years. No matter what, but they cling to hope. The moment the stock comes back to the bhav at which they bought, they will sell it. They believe they saved money by not booking a loss. But they ignore opportunity cost, as well as inflation.

The reason this behaviour is so common isn’t just lack of knowledge—it’s human psychology. And when markets recover, the number of accidental “Bhav to Bhav” investors quietly swells. These decisions may feel personal and justified, but they are, in fact, rooted in predictable psychological patterns. This is where Prospect Theory enters the conversation.

The intersection of human psychology and finance—often explored through the fields of behavioral finance and financial psychology—reveals that our money decisions are far from purely rational. In this article we have tried to illustrate the interaction of human psychology & finance through Prospect Theory.

Prospect Theory; Losses Hurt More Than Gains Feel Good.

Prospect theory, developed by psychologists Daniel Kahneman and Amos Tversky in 1979, revolutionized the very understanding of how humans make decisions involving risk and uncertainties. It challenges traditional economic models (like expected utility theory) by demonstrating that people are not purely rational actors but are highly influenced by cognitive biases and emotional responses to gains and losses.

According to prospect theory, people experience the pain of losses about twice as intensely as the pleasure of equivalent gains. This “loss aversion” leads investors to hold onto loss making investments longer than what is rational, hoping to break even some day.

Below are the key principles of Prospect Theory which are discussed with example for better understanding.

i. Loss Aversion

Losing Rs. 10,000 causes more emotional distress than the happiness from gaining Rs. 10,000 and leads to risk-averse behavior for gains.

Loss Aversion can be understood by two distinct phenomena in human behavior a) concave for gain and b) convex for loss.

a. Concave for Gains:

The value function is concave for gains, which means that as people experience more gains, each additional unit of gain provides less additional satisfaction. This concavity also reflects risk aversion: when faced with a choice between a certain smaller gain and a larger but uncertain gain, people typically prefer the sure thing, even if the risky option has a higher expected value (preferring certainty over larger, uncertain gains).

Example

Suppose you are offered two options:

Option A: Receive Rs.45,000 for sure.

Option B: 50% chance to receive Rs.1,00,000, and 50% chance to receive nothing.

Although the expected value of Option B is Rs.50,000 (0.5 × Rs.1,00,000 + 0.5 × Rs.0), most people choose Option A—the guaranteed Rs.45,000—because the psychological value of a certain gain is perceived as higher than the risky prospect of a larger gain.

This behavior demonstrates the concave for gains principle: people are risk-averse when it comes to potential gains, preferring a certain, smaller reward over a gamble with a potentially higher payoff. The satisfaction from the first Rs.45,000 is much greater than the incremental satisfaction from the chance to gain an additional Rs.55,000.

b. Convex for Losses:

The value function is convex for losses, meaning that as losses increase, each additional unit of loss feels less painful than the previous one. This shape of the value function leads people to become risk-seeking when faced with certain losses: they prefer to gamble to avoid a sure loss, even if the gamble has a lower expected value.

Example

Suppose you are given two options:

Option A: A sure loss of Rs.5,000.

Option B: A 50% chance to lose Rs.10,000 and a 50% chance to lose nothing.

Although the expected value of both options is the same (average loss of Rs.5,000), most people prefer Option B—the risky choice—because there is a chance to avoid any loss at all. This preference for risk in the domain of losses is a direct result of the convex shape of the value function for losses in prospect theory.

A real classic example of loss aversion occurs in investing: Suppose an investor owns two stocks—Stock A, which has gained 15% in value, and Stock B, which has lost 15%. Even if the analysis suggests that Stock A still has strong future prospects and Stock B is unlikely to recover, the investor is more likely to sell Stock A to “lock in” the gain and hold onto Stock B, hoping it will rebound. This behavior is driven by the pain of realizing a loss, which feels much stronger than the pleasure of realizing an equivalent gain. As a result, investors often hold onto losing investments much longer than is rational, potentially suffering even greater losses. This tendency to avoid realizing losses even at the expense of better financial outcome is a hallmark of loss aversion mentioned in the Prospect Theory.

ii. Reference Dependence

Decisions are evaluated relative to a subjective reference point (often the status quo), not absolute outcomes. A Rs.10,000 gain feels different if you compare it with another Rs.10,000 than comparing the same gain with Rs.1,00,000.

Reference dependence means that people evaluate outcomes as gains or losses relative to a specific reference point—such as their expectations, previous experiences, or the current status quo—rather than in absolute terms. This also indicates individual’s susceptibility to anchor bias and contrast effect.

Example: Salary Expectations

Suppose you expect a 10% pay raise this year. When your actual raise is announced, it turns out to be only 5%. Even though your salary has increased, you may feel disappointed or even perceive this as a “loss” because it falls short of your reference point (the 10% you expected).

Conversely, if you had expected no raise at all and received a 5% increase, you would likely feel pleased and consider it a gain. In both cases, the objective outcome (a 5% raise) is the same, but your emotional response depends entirely on your reference point.

Imagine you are in a shopping mall and see two different deals (for two different items)

Deal 1: Save Rs.50 on a Rs.100 item (pay Rs.50 instead of Rs.100)

Deal 2: Save Rs.50 on a Rs.500 item (pay Rs.450 instead of Rs.500)

Obviously, you feel much more excited about saving Rs.50 on the Rs.100 item than on the Rs.500 item. (Ignoring the fact that the offer is for different commodities which have different utilities in your life)

This illustrates how reference dependence shapes satisfaction and decision-making: the same outcome can be viewed as a gain or a loss depending on your reference point.

iii. Diminishing Sensitivity

Diminishing sensitivity in prospect theory means that as the size of gains or losses increases, the psychological impact of each additional unit becomes smaller. In other words, the difference between small amounts feels more significant than the same difference between larger amounts.

Imagine you find Rs.100 lying on the road — you feel quite happy. Now, suppose you find Rs.200 – you’re still happy, but not twice as happy as you were with Rs.100.

If you found Rs.1,000, you would be even happier, but the extra happiness you feel from Rs.1,000 compared to Rs.200 is less than the happiness difference between Rs.100 and Rs.200.

As the amounts grow larger, each additional rupee adds less emotional impact — this is called Diminishing Sensitivity.

iv. Probability Weighting.

Probability weighting refers to the tendency of people to perceive the likelihood of events in a biased, non-linear way overestimating the chances of rare events and underestimating the chances of common ones.

This phenomenon is contrary to earlier discussed loss aversion concept, sometimes people tend to choose a less probable option. Confirmation bias also plays a major role in such decision making.

Suppose a person is offered two choices:

Option A: A 1% chance to win Rs.1 crore.
Option B: Rs.1,000 guaranteed.

Many people feel overly attracted to the tiny 1% chance of winning Rs.1 crore. Prospect Theory explains this as probability weighting: people tend to overweight small probabilities, giving them more psychological importance than they statistically deserve. As a result, rare events feel more significant than they objectively are, leading people to prefer risky options like lotteries.

In India, millions of people buy lottery tickets despite the extremely low probability of winning. The actual odds of hitting the jackpot are minuscule, but people tend to overweight this small probability in their minds—believing they have a much higher chance of winning than the statistics suggest.

v. Framing:

Framing is when the way information is presented influences decisions, even if the underlying facts remain the same. Reacting differently to identical outcomes based on how they’re presented (e.g., “70% success rate” vs. “30% failure rate”). This effect is frequently seen in marketing, public policy, and daily financial decisions. It can be in negative frame or positive frame depending on the product/ services they are pitching.

Example: Electricity Bill Payment

Many Indian electricity boards and utility companies frame their payment options to influence consumer behavior

Negative Frame: “Pay your bill after the due date and pay a Rs.100 late fee.”

Positive Frame: “Pay your bill before the due date and get a Rs.100 discount.”

Although the economic outcome is identical (paying on time saves Rs.100), consumers are more motivated to pay before the due date when the message emphasizes avoiding a penalty (negative frame) rather than earning a reward (positive frame).

This is because people are generally more sensitive to avoiding losses than to acquiring gains—a phenomenon closely linked to loss aversion. The way the message is framed taps into this psychological bias, leading to higher rates of timely bill payments.

vi. Mental Accounting: Categorizing money into separate “mental accounts”

Mental accounting is the tendency to categorize, budget, and treat money differently depending on its source or intended use, rather than considering all funds as part of a single pool. This bias can shape financial decisions in both helpful and harmful ways and is widely observed. Let’s understand it with few examples.

Examples

i. Bonus as “Free Money”: Many people treat annual bonuses or festival gifts as “extra” or “free” money, often spending it on luxuries or celebrations, rather than saving or using it to pay off debts—even if they have outstanding loans.

ii. Separate Funds for Specific Goals: Households may keep separate “money jars” or dedicated bank accounts for weddings, vacations, or festivals, while simultaneously carrying high-interest credit card debt. They may avoid using these earmarked funds to pay off debt, even if it would be financially optimal.

iii. Expense Budgets: Someone may budget strictly for monthly groceries but splurge on eating out, rationalizing that restaurant expenses come from a different “mental account”.

iv. Investment Reluctance: An individual might hesitate to invest from their savings account, feeling that money set aside for emergencies or specific goals should not be touched—even if there’s a good investment opportunity.

Conclusion:

The intricate relationship between psychology and financial decision-making reveals that Money decisions are rarely just about money—they are battles between logic and emotion, risk and reward, fear and hope.

Prospect Theory uncovers the subtle ways our minds play tricks on us: clinging to losses, chasing unlikely wins, and reacting differently depending on how choices are presented. These psychological patterns quietly shape our financial fate every day and explain why people often make seemingly irrational financial choices, but once we recognize them, we gain the power to step back, question our instincts, and make choices that truly serve our long-term goals.

Understanding these behavioral tendencies equip individuals with greater self-awareness, potentially enabling more balanced and informed financial decisions. Since our financial lives continue to be shaped by both numbers and emotions, We need to consider that mastering money isn’t just about understanding finance—it’s about understanding ourselves.