Remember the market crash in the 17th century, junk bonds in the 1980s, and Internet stocks in the 1990s? These are phenomena that are cited by theorists to explain the financial behavior of most investors.
It is claimed that market prices can be affected greatly by the decisions of irrational investors.
The same belief is claimed by Adam Smith in his non-fiction book “The Theory of Moral Sentiments” which has two major observations that associates financial behavior to the result of investors’ decisions.
These are: 1. “Investors (and people in general) make decisions on imprecise impressions and beliefs rather than rational analysis.” You have seen this every day.
People come from different groups with different cultures, faith, and tradition. Sometimes, these things cloud up their reasoning, making them decide inefficiently in the belief that it is the best choice they are making.
But there are times, and not always, that these decisions turn out to be a bad move. Even with these, people with very great foundation on their belief will still hold on to his or her decision in the belief that it is meant to be—in denial of what just happened over his or her badly thought of decision.
In his fact-finding book “The Theory of Moral Sentiments”, Adam Smith also observes the same thing. He elaborately showed how irrational an investor can make decisions by simply looking at his own impressions and beliefs.
Unlike in the efficient marketing theory, Smith quotes that people who are greatly influenced with what they believe in can abruptly go for a decision not considering everything that can make or break the result of such decision.
And so, there is always a high probability that the by-product of these not so thoroughly thought of decisions are usually the worst for the market.
2. “The way a question or problem is framed to an investor will influence the decision he/she ultimately makes.” If you would be asked if you want to enroll in a particular college, would you say yes?
But if the question is rephrased to say, if you are willing to waste four long years in one place, would your answer be the same? This is a very farfetched example on how a person’s answer may be affected in respect to the same question that was asked in different ways.
This is similar to what Adam Smith claims in his second observance that says a problem and how it is framed to an investor can affect the way he or she decides on it.
The financial behavior expert believes that because of the beliefs and impressions that a person or an investor has on top of how the questions are asked and the decision of that person is influenced. One question that challenges or blends perfectly well with these beliefs and impressions and the investor is carried away.
As Adam Smith concludes, “These two observations largely explain market inefficiencies; that is, behavior finance holds that markets are sometimes inefficient because people are not mathematical equations.
Behavioral finance stands in stark contrast to the efficient markets theory“. True to this, finance behavior is actually a counterpoint of the efficient market theory because the former states that investors only act and decide rationally.
Other financial behavior theorists have the same observation as Adam Smith, quoting even the market phenomenon of the Dutch tulip bulb mania which had been very controversial for causing the market to crash in the 17th century. Other examples to the effects of irrational financial behavior are the junk bonds in the 1980s and even the Internet stocks in the 1990s.
If irrationality is actually affecting the reasoning and decision-making factor of an investor, what is the best next thing for you to do? Nothing. You see, these are your beliefs that rooted way back when you were young. You don’t have to change them just because you have become a finance aware investor.
But there are things that you can look into before you finally give your nod to a business partner or another investor. You should be able to assess if the investment will:
1. Provide you with the best result. There are some decisions that are life changing. If you are deciding on a big but risky investment, you better be a bit skeptical about it.
Try not to immediately say yes or no to a business partner or adviser. Find some facts that will back whatever decision you may have. Sometimes, some investments are not so good at face value.
2. Be the best choice you have. Always ask yourself if this is already your best choice. If it is, you can freely decide to pursue an investment. If you are not sure, find hard facts that will help you come up with the best answers.