Conventional wisdom views security markets as being efficient based on the rationality of investors.
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The efficient market hypothesis states that rational investors will quickly take advantage of any deviation from a security's true value.
Bringing security prices quickly back to an efficient equilibrium, rational investors capitalize on the irrational actions of other investors. However, the efficient market hypothesis fails to explain several abnormalities that occur in the stock market. Sustainable periods of market irrationality have existed in the past with no satisfactory explanation. To explain these irregularities, a new and controversial field has emerged called behavioral finance.
A good example to demonstrate an abnormal market situation involves the initial public offering of Palm Incorporated during the height of the technology boom in the late 1990s and early 2000s. When 3Com Corporation offered Palm for public sale on March 2, 2000, overeager investors continually purchased the shares at an incredible pace. By the end of the day, Palm's worth had surpassed that of its parent company, 3Com, which owned ninety-four percent of Palm. Moreover, Palm's worth surpassed that of enormous companies like Ford and General Motors.
Investors were hard-pressed to understand why investors would not just invest in the cheaper 3Com as a means to own Palm. Especially with regards to IPOs, the efficient market hypothesis could not explain the large amounts of irrationality that were taking place during the technology bubble. The stock prices of many technology companies did not represent their true value, but rational investors did not take advantage of these deviations. The reality that the bubble was sustained for so long directly contradicts the principles of efficient markets.
Concentrating on irrational behaviors that lead to investment losses rather than gains, behavioral finance incorporates finance with the psychology of investors.
These irrational behaviors are not random mistakes but systematic errors that investors tend to make repeatedly. These mistakes, according to behavior finance, are caused by the nature of the human mind.
Contrary to traditional finance which views all investors as rational, value maximizing individuals capable of applying probability and decision making under uncertainty, behavioral finance asserts many behavior phenomenon that impact investor decisions. For instance, individuals sometimes act irrationally and make decisions based on emotion rather than reason. Also, persons fail to process probability and make decision accurately when facing uncertainty. Moreover, individuals often rely on heuristics or rules of thumb when deciding their actions. Finally, called framing, investors can make errors based on the form of the information they use. Research has shown that individuals can choose options with less expected value based on how the information is presented.
Based on these habits, several behavioral irrationalities in finance have been identified.
Behavioral Phenomenon in Finance
People can make judgments based on stereotypes. They make assumptions based on information that has no bearing on reality. For instance, if a company has a history of releasing poor results, some investors will characterize the company as being lousy and assume they will offer poor results in the future. Even if improvements are visible, their characterizations will blind their judgment. Moreover, they place too much weight on recent observations rather than long-term knowledge.
An easy way to demonstrate the gambler's fallacy involves the act of flipping a quarter several times. If the quarter lands on heads five times in a row, a person incorrectly believes that the probability of the quarter landing on tails increases. In reality, the probability that the quarter lands on either side is the same, fifty percent, regardless of the outcome of the previous tosses. This translates into a person selling his or her shares based solely on the fact that the stock has risen for several days straight and must decrease.
Many people tend to be overconfident in their decisions especially after a series of successes or correct judgments. This overconfidence can lead to excessive risk taking and decreases in gains.
Anchoring and Adjustment
Individuals tend to be anchored to their original beliefs and adjust slowing to new and contradictory data. This helps explain the reasoning for some securities to be mispriced. For instance, if a company unexpectedly reports a substantial increase in earnings, the market occasionally under-reacts to the announcement. Despite the increase in earnings, the company's stock price does not rise because investors believe the increase is only temporary. They remain anchored to their original judgments regarding the company's performance and will only slowly adjust to the new, positive information.
With herd behavior, investors make decisions based on what everyone else is doing. They believe that a group of investors must collectively have more information that the individual; therefore, they substitute their own rational decision making for the decision making of the majority.
Psychologists suggest that people feel the pain of a loss two and a half times more than the joy of a gain. Consequently, when the stock prices of a person's portfolio increase, he or she will feel happy, but, if the prices decrease by the same amount, he or she will feel considerably more miserable. Due to this reality, investors are quick to replace their losing investments even if they are part of an efficient, diversified portfolio. This usually results from investors reacting to day to day changes in security prices rather than taking a more long-term approach.
Get Even At All Costs
Many investors aim to avoid losses and are quick to capitalize on gains. Accordingly, an investor will more likely sell a security in a winning position than one in a losing position. Because the investor is loss averse and wants to get back to even, he or she will hold onto the losing security hoping that it will come back even if no evidence exists to warrant such an expectation. On the other hand, an investor will sell a winning security to protect his or her gains despite any information that suggests the stock price will increase further.
Many investors approach investing in security markets in the same way they approach gambling in casinos. It is much easier for them to lose money that they have gained rather than their original capital. Because they place profits in a separate category or considered them "house money," losing profits is mentally easier than losing the initial principle of an investment. In the same way, dividends are easier to spend or lose than the original investment.