Rational investment decisions all in the mind

Monday 29 March 2004

Are investors rational? Common sense suggests the answer is: not always. There are market bubbles and crashes, we try to avoid risk, we forget, we remember creatively, and we fall in love with certain stocks.

By The Landlord

The Efficient Markets Hypothesis - accepted by many as the best explanation for the way sharemarkets work - says these are just anomalies in an otherwise tidy and rational world. The field of "behavioural finance", on the other hand, acknowledges that investors are human and was devised as a way of explaining these so-called anomalies in rationality.

But these behaviours happen too often to be some kind of malfunction. What an economist sees as an anomaly is completely understandable to a psychologist.

The economist sees irrational investors as failures in the noble tradition of rational thought. Psychologists just see humans doing what comes naturally. Financial gain and loss aren't the only things at stake when we make decisions about money. It's far more messy and interesting than that.

Short-term self-protection, ignorance and excitement, as well as the usual biases in the way we see things, are at the root of most of the failures of judgment.

Failure to sell losing shares, called loss aversion, happens when the immediate pain of selling now, when the price is down, seems greater than the eventual pain when they are nearly worthless. But the price will come up again, right? Over-optimism is another trap.

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