Efficient market hypothesis creates a rational basis for investing in the securities markets. For example, it states that everything that can be known about a security is known at the same time by everyone. Based on this knowledge, all securities are priced efficiently, in relation to each other, and there is no inside knowledge or competitive advantage that impacts the pricing of securities.
Behavioral finance relates to socionomics. Talk with a financial advisor in Norman, OK regarding your feelings about investment performance.
For example, when 100 analysts are following the same security, it stands to reason, everything that can be known about the security is known and it is reflected in the current price of the security. One analyst does not have a competitive advantage over the collective wisdom of the other 99 analysts based on financial information being made public to everyone at the same time.
You could call this a rational model for the pricing of securities.
However, the data for securities is subject to interpretation and the market is made up of millions of irrational humans who can be driven by their emotions when they invest in the securities markets.
Their behavior has a major impact on the performance of the securities markets. Some people call this herd instinct.
What is behavioral finance?
Behavioral finance is an attempt to explain how emotion impacts the decision making of investors when they make buy/sell investment decisions for their portfolios.
- How are their decisions impacted by their emotions?
- For example, how much money will they make if they are right (greed)?
- How much money will they lose if they are wrong (fear)?
Many experts believe these primary emotional responses are the underpinnings of the performance of the securities markets that produce big swings that are both rational and irrational. Investors tend to buy when they are comfortable, i.e. the markets are going up and they tend to sell when they are uncomfortable, i.e. the markets are going down. A rational investor might do the exact opposite.
Investors would have a significant competitive advantage if they could predict the future behavior of other investors, that is buying that would drive the markets up and selling that would drive the markets down.
Who practices behavioral finance?
Some market movement is exacerbated by the herd instinct of large numbers of investors moving in the same direction at the same time. They are driven by emotions that can be rational or irrational.
It is often said that individual investors a.k.a. Do It Yourselfers (DIYs) are the ones who are most likely to be driven by their emotions when they invest their assets in the securities markets. On the other hand, professionals are supposed to be more knowledgeable, disciplined, and less prone to emotion-backed decision making. Consequently the professionals are considered the more stable of the two.
However, individuals still impact the performance of the markets with their behaviors, so even the professionals have to be aware of individual investor behaviors. Change is possible with the guidance of a financial advisor in Norman, OK.
How does the media influence the behavior of individual investors?
The media should not impact the behavior of investors, but it has a pervasive influence that includes financial information and recommendations. The key to their success is their ability to reach large numbers of people, which impacts the behavior of investors.
There are three reasons why investors should be cautious about following the recommendations of the media.
- If the media is reporting on it then it has already happened. The market has already reacted to the news. This is the equivalent of investing based on yesterday’s news. In another example, investors make investment decisions based on what is printed in subscription-based newsletters. But, the financial news is dated because it already happened days or weeks ago.
- The role of media’s talking heads is to read what is printed on their studio’s monitors. They are not investment analysts or portfolio managers.
- Their opinions are not the same as investment advice from experienced financial professionals.
How does fear of loss impact investor behaviors?
Given a choice, more investors are conservative than they are aggressive. Their fear of loss exceeds their willingness to take incremental risk that may or may not produce a superior return.
This could be construed to mean investors get out of the securities markets faster than they get into the securities markets.
There is also a tendency for investors to sell winning positions and hold onto losing positions until they recover. This behavioral effect directly contradicts the famous investing rule, “Cut your losses short and let your winners run.”
How do investment horizons impact behavioral finance?
Your investment horizon determines when you need the assets that are being invested in the securities markets. For example, when you begin funding the college education of children or start your retirement years.
It stands to reason, the longer the investment horizon, the more time you have to recover from down markets. The shorter the investment horizon, the less time you have for recovery. Therefore, investment horizon is one of the best indicators of risk tolerance.
Assets have purposes and the purposes have investment horizons. The horizon impacts the behaviors of investors.
What are the key differences between traditional and behavioral finance?
Traditional finance makes the broad assumption that investors are rational human beings. They gather and process information in a rational manner. They use the information they gather to make prudent decisions that are based on their immediate and long term needs.
This is the objective world of the rational investor.
Behavioral finance assumes investors are not rational. They make decisions that are based on the two primary emotions (greed and fear). And, there is a herd instinct that drives group behavior. Group emotions are important because they have a big impact on the financial decisions of individual investors.
This is the subjective world of the emotional investor.
If you feel like your emotions are getting the best of you, or want an honest risk evaluation, call TRAC Advisor Group to discuss your retirement planning and beyond.
Financial planning and investment management should not be done alone. At TRAC, we provide tactical and alternative investment management. Think of this as a way you can add predictability and stability to your portfolio holdings to avoid major market declines.
TRAC Advisor Group Inc. is a full-service, fee-based financial advisory firm in Norman, OK. We offer independent investment advice and help people withstand any type of market volatility with confidence.
As an independent investment advisor, we can offer alternative investments like numismatics and precious metals to diversify and hedge against uncertain times. With a straightforward and direct planning style, you can trust that we’ll keep you on track towards your financial goals.