In the world of finance and investing, it’s not safe to think that investors are always on the rational side of things. In fact, there’s a whole study that attempts to explain why the market shows irrationality in many events.
The Rationality Theory
The Efficient Market Hypothesis purports that individuals behave in a rational manner. At the same time, all the existing information available on the markets are already reflected in the investment process.
However, researchers have questioned this theory and have offered evidence that rationality is not always dominant as the assumption might suggest.
Here are some possible explanations.
Investors have the innate fear of regret. This deals with the emotional reaction that people experience after knowing that they’ve made an error in their judgment and decision.
In the lens of investing, an investor might be confident at first at the stock he holds. Upon realizing that he made a mistake and he has to sell the stock, he becomes emotionally affected by the price at which he bought the stock.
So, in the end, they avoid selling the stock to avoid admitting that they have made a mistake. This comes with the embarrassment of having to face a loss.
People tend to place specific events into mental compartments and the difference between these compartments at times affects our behavior—even more than the event.
One telling example of mental accounting is an investor’s refusal to sell a poorly performing stock that has once had soaring gains.
Prospect and Loss Aversion
The prospect theory tells us that people express a different kind of emotion toward gains and toward losses. Individuals are more worried about the prospective losses than they are excited for the equal gains.
Meanwhile, the loss aversion theory explains another reason why investors might choose to hold their losses all the while selling their winners. The explanation is that they may believe that today’s losers may outperform the winners in the future.
Without better or new information, investors usually assume that the market price is the correct price. People usually place too much emphasis on recent market views, events, and opinions. They then faultily extrapolate recent trends that differ from historical, long-term averages, and probabilities.
Investors may also get too optimistic when the market is going up, thinking that it will continue to do so. On the flipside, investors also become ultra-negative when downturns happen.
The result of anchoring or placing too much importance on recent events while ignoring historical data, is overreacting or underreacting to market events that end up in prices falling too much on bad news and rising too much on good news.
In general, people tend to rate themselves above average in their abilities. They also overestimate the precision of their knowledge and their knowledge in comparison to others.
There are also investors who think they can consistently time the market movements. However, reality suggests that that is not the case. Overconfidence can result in excess trades, with trading costs denting profits.