Behavior Finance

Studying this subject gives clues and even so guidance as to why investors tend to be irrational, and shows how it is possible to profit from this irrationality.  The key to investor irrationality is that in many ways rationality in markets is counter-intuitive.

Diversification

This tends to be the mantra of investment advisers and seems to make a lot of sense because it implies the spreading of risk nad a rational allocation of resources.  Yet countless stuidies have shown that diversification is a lousy investment strategy.  Diversification rarely works particularly well, and once asset prices start to fall it becomes a lousy way of preserving wealth.  Why would you want to put money into your 35th-best idea?  In other words, if you know that, say, five stocks are great performers and provide consistently good returns, why would you want to go out and buy another 30 stocks which are nothing more than so-so?

Prospect Theory

Investors love to buy shares when they are at their most expensive and they rush to offload stocks when prices fall.  This is because investors were more distressed by the prospect of loss than motivated by the possibility of gain.  Thus, they take greater risks to avoid loss than they would to achieve a gain.

Disposition Effect

Many investors hold on to bad investments for too long and sell winners too soon.  The failure to sell poor investments is, in part, explained by a reluctance to admit mistakes and it is this that also explains why investors are rational neither about buying nor selling.  Investors, understanably, want to feel good about their decisions and thus they filter out bad news about an asset and focus on favorable news.  They also have an alarming tendency to disregard their own experience of investment failures.

Irrelevant

Investors can easily be swayed by factors entirely irrelevant to market conditions, such as the weather at the time of the decision.

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About Andre

Experience Business Developer & Alliance Partner Manager with Strong Technical Background Dealing with Complex Solutions
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