Section 5.4

Fundamentals of Market Investing by Adam J. McKee

Psychological Risks

Classical economics assumes that investors incorporate all necessary information available to the public according to the efficient market hypothesis.  It further assumes that investors are impartial in analyzing securities and choosing stocks.  However, psychologists have found that people do not behave as rationally as economists long supposed.  Research into market “anomalies” has supported the theoretical idea that investors are not always as rational as they are portrayed to be.  These anomalies can be explained by the emerging area of finance called behavioral finance.

Behavioral finance considers how various psychological traits affect how individuals or groups make decisions and act on those decisions as individual investors as well as professional analysts and portfolio managers (the science tells us that the pros aren’t very different from the rest of us in their cognitive errors).  Behavioral finance (or behavioral economics more generally) tries to understand how emotions and cognitive errors influence behaviors of individual investors.  It also seeks to explain why and how investors can act “beyond the boundary of rationality” in ways that contradict the rational choice models of classical economics.

Much of the scholarly work done in behavioral finance stems from earlier work in the area of cognitive psychology.  Cognitive psychology is a branch of psychology that looks for explanations of human behavior based on how people think, reason, and make decisions.  Researchers in behavioral finance believe that a number of beliefs and preferences affects investors’ decisions.

The resulting beliefs and biases will cause investors to overreact to certain types of financial information and underreact to others, leading to irrational decisions and affecting their risk-taking behaviors.  The behavioral finance theory branches out to form the heuristics theory that is referred to “rules of thumb.”  Heuristics makes decision making easier especially in complex and uncertain environments by using “common sense” to solve a problem.  Heuristics also simplifies the decision-making process by identifying a defined set of criteria to evaluate.

When it comes to market investing, the best strategy is often to do the opposite of what everyone else is doing.  Traders have a simple formula to deal with extreme market conditions:  If there is a panicked sell-off, you should be buying.  If euphoria rules the day and prices have gone beyond the scope of reason, then you should sell.  If you are a long-term investor with an investment plan that reflects your risk tolerance, then you need just stand there.

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Last Updated: 6/25/2018

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