The financial market is an information jungle with constantly arising dangers, opportunities, delusions, and discoveries. How to increase the chances not only to survive in this severe environment but also get profit? What analysis methods can you rely on? What risks are acceptable and which strategies are likely to lead investors to a great success?
Apparently, traditional finance experts have no certain answers to the questions above, but theorists of behavioral finance claim that they do. They believe psychology knowledge can really help us understand the financial market and even provide us with practical strategies for selecting stocks and making right investments.
And here is how it works…
Traditional Finance vs. Behavioral Finance
Behavioral finance offers investors some interesting descriptions and explanations of how emotions and distortions affect stock prices. This research area claims that people are far from being as rational as it’s described in the traditional finance theory.
So, the idea that psychology rules the stock market goes against the established theory about the efficient financial markets and rational investors. Supporters of the efficient market hypothesis believe that any new information related to the company’s value gets to the market prices through the arbitrage process.
But those who have gone through all the Internet technology procedures and experienced a subsequent collapse, it would be hard to believe in the efficient markets theory anymore. Behavioral finance experts explain that irrational behavior is not an extraordinary, but rather a common thing. In fact, researchers were able to reproduce the market behavior using very simple experiments.
The Importance of Losses vs. Value of Profits
One of the experiments implied offering someone a choice between getting $50 or getting a chance to flip a coin and either win $100 or not win anything at all. Most likely, a person would choose to stay out of risk and get only $50. And on the contrary, if you’re offered a choice between losing $50, and flipping a coin to either lose $100 or lose nothing, a person would probably want to flip a coin. The chance to try your luck and flip a coin is offered in both scenarios, but people will go for it only when they know they could save themselves from losses, although there is a chance to lose even more. People tend to believe that the ability to win back their losses is more important than the opportunity to win more.
The priority of avoiding losses (“loss aversion“) refers to investors as well. And here is the proof. Think of how shareholders of Nortel Networks watched the shared drop from $100 per share to less than $2 in the early 2000s. Regardless of how low the price has fallen, investors believe that it will eventually rise again sometime, so they are still holding their shares.
The truth is, making wrong investments can lead to a financial collapse when the only choice would be taking loans for a short term or using other credit options. In case this ever happens or already happened to you, at least make sure to find a reliable lender with the help of Personal Money Service.
Widespread Herding or Independence
Widespread herding behavior explains why people tend to imitate others. When the market moves up or down, investors fear that others know more or have more detailed information. As a result, they are willing to do what others do.
Behavioral finance experts also found that investors tend to attach great importance to assessments that one got from a small data sampling or from individual sources. For example, investors are likely to attribute the fact that an analyst chooses winning shares to his own skills – not just his luck.
On the other hand, it’s rather hard to shatter investors’ beliefs. In the late 1990s, most of them had a common belief that any sudden drop in the market is a good time to buy. These views continue to live in their minds even more. Investors are often too confident in their assessments and tend to act as soon as something screams out, rather than sticking to a golden mean.
So How to Invest Wisely Using Knowledge of Behavioral Finance?
There is a plenty of so-called “anomalies” that might affect “perfect and rational” investors make not-so-perfect decisions. To those we include:
- Attention Bias – suggests that people are likely to invest in well-known companies even if others offer better returns;
- National Bias – Americans will invest in American companies, although foreign counterparts might offer better returns;
- Underdiversification – holding fewer stocks is considered more convenient for investors even though going for more will help them earn more money;
- Cockiness – when things go well, investors feel confident and not willing to change a strategy because they are “doing it right”, although it might be a luck or other factor to cause their success.
The truth is, many of our decisions as investors depend on a human factor even if you are not thinking about it subconsciously. Once you “turn off your humanity” and take a look at the stock market, you will probably recognize your mistakes at once. Just ask yourself such questions like: “How often do I think I am right but then I fail?” or “How often do I blame outside factors for my losses?” or “Have I ever sold a stock when I was angry or bought one when I felt like it?”
Most importantly, you should figure out whether you always have enough information to make a wise investment decision. Of course, you can never know all the details before selling or purchasing stocks but making a research is a must. Finally, don’t forget to leave your emotions and biases behind in order to make a logic and objective choice.
End of the Line…
Behavioral finance does not offer investment miracles, but perhaps they will help investors learn to monitor their actions and this in its turn will help them avoid further investment mistakes.