On a regular basis, investors come to deal with a variety of issues. Unfortunately, we are not rational when it comes to dealing with money. There is a whole field of study focusing on our often-strange investor behavior.
Many are aware of the standard economic theory that is based on the following belief. Those individuals are rational and all the information provided comes from the investment process. This is the Rational Actor Theory (RAT). Following this theory, people believe that they make rational choices. They believe in the long run it will be beneficial to them – based on the information they are provided with. However, not everyone believes in this theory.
A study was released in 2001 called “Quantitative Analysis of Investor Behavior”. Dalbar’s study explains that investors fail to achieve or even match the overall market averages. Dalbar found that in the 17-year period until December 2000, the S and P 500 returned approximately 16.29% per year. Achieving only 5.32% putting it at a 9% difference. During the same time period, an investor’s average annual income was 6.08 percent, while the long-term Government Index increased by 11.83 percent. The same research released another study in 2015 concluding that the average investor is not earning the average market index.
Behavioral finance makes it possible for us to understand the logic of this. It deals with the emotions behind each investor, the decisions they made, the regrets they may have. We have several mental compartments where we store specific information. Mental accounting is the way people categorize money mentally. Placing more or less value on money is dependent on which category it falls under.
If money is lost, for example, we treat it as if it had never been spent. If the same amount is spent, however, it is already being used. For example, when buying a worthy investment at the height of an economic boom and being wary to sell it when the net worth goes down. The investor, therefore, will feel the need to wait until the net worth goes up like it was when he originally invested.
Let’s discuss the prospect theory and loss aversion. This theory suggests that people express a different level of emotion towards gain than losses. People are more concerned about prospective losses than they are happy with equal gains.
Expanding on the prospect theory that comes to explain the following. An investor would rather hold onto a losing stock and remain in that risky position than sell the stock. They would prefer for the price to bounce up than invest when the price is reasonably low but can be an opportunity for gains.
The loss aversion theory points an additional reason as to why investors might hold on to their ‘potential losses’. They believe that today’s losers may potentially become tomorrow’s winners.
- It is important to note that in the absence of new and updated information investors believe that the market price is what is correct. They put too much trust in the system and its views.
- Emotions also play a huge part. People get optimistic and assume that the markets rise will continue and oftentimes it doesn’t. There are extreme cases that can lead to market panics and crashes.
- Overconfidence has become another issue. Investors oftentimes believe they know best and can time when the market will rise. Evidence proves otherwise. For more news updates, visit our homepage now and see our latest news article. Want to learn more about trading? Visit our education page now and learn for FREE!