Investor Irrationality and Self Defeating Behavior

Topics: Behavioral finance, Efficient-market hypothesis, Fundamental analysis Pages: 7 (2509 words) Published: April 15, 2013
A Critical Analysis of: Investor Irrationality and Self-Defeating Behavior

For many years, finance traditionalists have held on to the theory that markets are efficient and that prices correctly reflect the information available to the market as a whole. This has come to be known as the efficient market hypothesis which was originally postulated by Eugene Fama in 1965. After a thorough statistical study of the movements of investment prices Fama concluded that “such movements were essentially random and unpredictable” (Shefrin p.75). Fama pointed out that “in an efficient market, prices correspond to intrinsic (or fundamental) value” (Shefrin p.75). In short, what the theory concludes is that it is impossible to beat the market; that no investor can ever purchase undervalued stocks or sell stocks at inflated prices. The market will always correct itself by incorporating all relevant information into the price of a security thus eliminating an individual investor’s ability to outperform. EMH has grown to become a cornerstone of financial theory and is still applied by many traditionalists when attempting to explain the behavior of financial markets. While there is much evidence in support of this theory there is an equal amount dissention. There are many who argue that there is ample evidence available that counters the central ideas of EMH and demonstrate its shortcomings such as: individuals who have shown that they can consistently beat the market as in the case of Warren Buffet; or the recent bursting of the dot com and real estate bubbles, two events which clearly show that market prices can seriously deviate from their fair values. Given the mounting evidence in direct contrast to EMH “new attempts are being made to explain the behavior of financial markets, one of the foremost of which is in the area of behavioral finance” (Singh p.116). In his article Investor Irrationality and Self Defeating Behavior: Insights from Behavioral Finance, author Sudhir Singh discusses the central tenets of behavioral finance in an attempt to reveal its impact on “investment decision-making at the individual level” (Singh p.117). He presents the concepts central to behavioral finance and a number of psychological biases that result in poor investment decision. He then discusses their implications for financial markets and also presents strategies, which he believes, investors can follow that will aid them in avoiding the pitfalls that many of these biases lead to. Singh believes that the study of behavioral finance will have the greatest impact on the individual investor as the awareness it brings forth will keep them from exhibiting these suboptimal behaviors. Article Summary

In his article Singh states that “interest in behavioral finance has been fueled by the inability of the traditional finance framework to explain many empirical patterns, including stock market bubbles… these models are incomplete, since they do not fully consider individual behavior” (Singh p.116). A central component of EMH is that investors behave rationally, yet, the belief that human flaws are consistent and measurable is gaining traction in the financial industry and there are many who believe that this irrationality can be predicted and exploited for big gains. This is in direct contrast to the theory presented by Fama many years ago. Behavioral finance is now replacing the rational behavior of investors with “cognitive psychology (how people think) and limits to arbitrage (when markets will be inefficient)” (Singh p.117). More specifically it is challenging the long held notion that markets are efficient because they take into account all past and present information that is available to the market as a whole. Behavioral finance states that investors are not rational and that they will be swayed by psychological biases which in turn will impact the efficiency of markets. The biases highlighted by...
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