The efficient market theory states that at anygiven time, the price of a security fully reflectsall information that is available. The theoryfurther states that when new information is available,the market quickly absorbs it, and then the securityis priced accordingly. This ongoing process theoreticallycreates a very efficient and rational market.
Unfortunately, this theory has crashed headlonginto the reality that investors tend not to act rationally.Most people buy a stock believing that it isworth more or will be worth more than they paid.Many sell a stock believing the exact opposite. Thequest to understand the difference between oneinvestor's decision to buy and another's decision tosell resulted in the creation of a new field of studycalled behavioral finance.
The field of behavioral finance has really grownover the past several years as a means of explainingthe volatility of the stock market. Behavioral financeis based upon the belief that investors do not act nearlyas rational as was once believed. Emotions and biasfactor into the decision process that each investor goesthrough as they make the decision to buy or sell asecurity. The following list contains some of the trapsa rational investor will want to avoid:
•Optimism. Generally speaking, most investorsare optimists. If an investor did not believe the futurewas going to be better than the present, investingwould be completely irrational. However, an optimisticbias leads to bold predictions about the futurethat may be overstated. A perfect example is in thelate 1990s when we thought we were entering a newparadigm and the old valuation models no longerapplied to the market.
•Overconfidence. A fatal flaw in investing canbe when you're overconfident in your investmentdecisions. Investors tend to believe they possess superiorknowledge and can rely upon it to guide them togood investments and away from poor investments.Most investors acknowledge that there are inherentrisks in investing, however, most also believe thatthey are nearly immune to those risks.
•Loss aversion. Many investors feel the pain ofloss more intensely than the joy of gain. When theoutlook for an investment we currently hold changes,we tend to hold on to our "losers" to avoid the painof locking in a loss, but we will much more easilychoose to sell if we can lock in a gain. A more rationaldecision is to determine if the new outlook warrantsselling the investment or buying more. Whetherthe investment is currently at a gain or loss shouldnot factor into the decision.
•Herd mentality. Investors tend to follow thecrowd with respect to their investments. If aninvestor hears several people at a social gathering discussingan investment that they do not currentlyown, they have a tendency to want to purchase theinvestment. Whether or not this particular investmentfits into their goals and objectives will becomesecondary to not being left behind.
Unfortunately, no investor is completely immuneto emotional influences. Recognizing irrationalbehavior, however, can serve to minimize its impacton your investment returns.
Greg Reed, CFP®, CFS, CLU®, MBA, is the director of planning forSmith, Frank & Partners, LLC. He is a registered representative ofand offers securities and advisory services through NFPSecurities, Inc, member NASD/SIPC. He welcomes questions orcomments at 972-490-4377 or firstname.lastname@example.org.