Head Space: Understanding investor psychology can help you steer your clients toward good investing decisions in bad markets.

Since the dawn of stock trading, investors have acted gotten burned for acting on the basis of their emotions. Factor in fears over retirement assets, and advisors have quite a fight on their hands to keep their clients prudently invested in erratic markets. But understanding the psychology behind irrational investment decisions can help.

I'd like to share some "Investor Mind-set Realities" that have helped shape ING's advisor training program. These insights should help you serve clients better in adverse market conditions.

Investor Mind-set Reality No. 1: People don't know how to evaluate risk and reward. In an ideal world, or perhaps a Vulcan planet, investors would put their emotions aside and always act rationally in their own economic self-interest. But, we know from our own bank clients, that this is rarely the case. For example, according to the investment research firm DALBAR, from 1984 through 2003, the return for the S&P 500 averaged 12.98%. Yet, over the same time period, the average investor produced a 3.51% annual return. Why this vast difference? Research suggests that it comes down to unproductive decisions based on inaccurate estimations of potential gains or losses.

You may have read about psychologist and Nobel laureate Daniel Kahneman's ground-breaking studies of investors' inability to determine probabilities in order to weigh risk versus reward. He asked people to choose between two good outcomes: Choice A) There is an 80% chance that you will receive $4,000 and a 20% chance that you will receive nothing. Choice B) You will receive $3,000 with certainty.

In the study, 80% preferred the certain gain offered by Choice B. However, if we do the math, we know this is not a rational choice. The expected value of Choice A is higher-by $1,000 in four out of five cases-but that choice lacks the "certainty" element that investors covet.

Kahneman's study group was also asked to choose between two unpleasant options: Choice A) "There is an 80% chance that you are going to lose $4,000 and a 20% chance that you will avoid the loss." Choice B) "You will lose $3,000 with certainty."

In this case, 90% of the people in the study selected Choice A. Yet, in reality, Choice A's likely loss of $4,000 is worse than Choice B's certain loss of $3,000. This indicates how much many people are willing to gamble in order to avoid a loss.