Behavioral Finance and investing

A lot of investors have bad habits; they either take too little or too much risk in their investments that are long term. They would panic and sell which would follow a large drop in the market; and buy winners of the last years by chasing the returns. Deep insights into why investors so often make mistakes that are highly expensive can be provided by a proper study of the “Behavioral Finance.” These mistakes are done by the investors over and over again. By studying of psychology can affect finance logical explanations for an irrational behavior can be obtained.

Author Hersh Shefrin of Harvard Business School in his book, Beyond Greed and Fear describes patterns that are common in investor behavior. He states that a principle behavior is that the investors depend on the judgments that are based on stereotypes or the rules of the thumb.

Watch out for the rule of the thumb

Traditional finance is of the assumption that investors will formulate decisions that are on the basis of unbiased data. Unlike the traditional finance, behavioral finance is of the opinion that investors often depend on the rules of thumb to formulate their decisions. There is a good chance of the rules of thumb being inaccurate. So the investors end up making decisions that are bad. The typical faulty rule of thumb is to believe that the performance of the past indicates the performance of the future aptly. Investors who follow this fallacy are seen chasing hot funds by wrongly believing that the performance which is over period which is as short as a year will indicate that the manager of the fund is skilled, not lucky.

Construction of a strong portfolio or properly maintaining it is impossible by operating with the rules of the thumb. The common mistake made by most of the investors is that they trade too much. They are of the belief that to invest means to try to pick out of the winners and they would try with great dynamism.

Studies in the academics tell us though the traders that are frequent would normally earn average returns. A study was organized by Terrance Odean and Brad Barber (“Trading is Hazardous to Your Wealth,” The Journal of Finance, April 2000). The trading histories of investors that were more than 66,000 over the period of six years ending in 1996 were looked by the authors. Their findings were that the investors who traded the most had returns that were the worst.

Summary

Deep insights into why investors so often make mistakes that are highly expensive can be provided by a proper study of the “BehavioralFinance.” These mistakes are done by the investors over and over again. By studying of psychology can affect finance logical explanations for an irrational behavior can be obtained