Understanding Investors’ Stock Market Choices

Written by admin on December 12th, 2011

The main assumption of Traditional Finance is that investors are rational and evaluate risk and return in terms of expected utility. There are different ways of calibrating utility, but they all have the main characteristic that they represent assumptions about how investors express their preferences. Psychologists have documented systematic patterns of bias in how investors form views and take decisions. These psychological biases influence investment decision making and how investors form their opinions about the stock market.

Perhaps the most common characteristic of all investors is the fact that they regret risk. Regret is the emotion we feel when we think we should have acted in a way that would have led to a more favorable outcome. Several behavioral studies emphasize that regret from taking action is usually stronger than regret from decisions to take no action because of the losses involved in the process.

This means that ‘losses have a stronger emotional impact on investors than an equivalent amount of gains’ as the Prospect Theory suggests. Being built on a wide range of experiments related to investor behavior, Prospect Theory argues that investors will take quite large risks if they have some chance of avoiding certain losses, but they are quick to bank any gains. Investment banks tap into this investor preference through the sale of highly profitable structured products, which provide downside protection combined with leveraged positive returns.

Moreover, investors react differently to the fall of a stock price. If the investment is short-term, there is generally more regret than for a long-term investment. For investors, the main dilemma is related to how and when to proceed to new investment decisions, considering the investment risk involved.

Unlike risk adverse investors, aggressive investors may regret risk from inaction more than taking risk and suffering losses.

However, cautious investors may experience anxiety about the possible consequences of making different policy choices. This may lead to inaction, even if an investor thinks that taking action is necessary. In reality, avoiding taking action is related to the fear that any action will turn out to be less than ideal.

Another important consideration is that investors are almost systematically overconfident in their own judgments. This means that they have a natural tendency to attribute any investment failure to bad luck rather to a lack of skill. For instance, investment management underperformance is often attributed to bad luck, while overperformance is almost always attribute to good skills.

Overall, investor behavior is highly subject to psychological biases and as such it cannot be rational. Unlike Traditional Finance, Behavioral Finance emphasizes a lot on the market influences that affect investment decision making. The insights of Behavioral Finance help in understanding investor preferences. On the other hand, they do not provide an excuse for ignoring the fundamental principles of diversification, correlation between investments or the need to craft investment strategies that are based on the time horizon of investment objectives.

Tags: , , , , ,

Leave a Reply