Behavioral Analysis of Investors: A Look at Irrational Behavior in Finance
When it comes to economics and market analysis, there are a few schools of thought. The bulk of modern economic theory is based on the assumption that people generally behave rationally when making financial decisions. The Efficient Market Hypothesis relies on this assumption; it states that market prices are efficient, or always “correct”, thus making it impossible to beat the market. This theory is controversial, since there is evidence of people beating the market over long periods of time (pick any successful investor such as Warren Buffett), and there is evidence of prices deviating far from their efficient/fair prices (take the 1987 stock market crash).
The opposing school of thought regarding economics revolves around behavioral finance, which explores how human emotions and other factors influence individuals to making irrational decisions versus rational ones. This article expounds on several theories of behavioral finance. One of these theories is the regret theory, where, for example, an investor is faced with selling a stock for a loss because it has decreased in value. Rather than sell the stock for a loss, they instead keep the stock to avoid the regret of knowing they made a bad investment, or perhaps to avoid the regret/embarrassment of simply reporting a loss. This is not the only reason investors hang onto poor stocks; the prospect theory also explains how investors hold on to such stocks simply in hopes that it may bounce back and increase in value. Regardless, this is one faction of regret theory. Another example of regret theory is when a stock that an investor chose not to buy ends up increasing in value tremendously. It is with this context that the article states that individuals tend to avoid this regret by frequently buying popular stocks, or to put in terms we have heard in class, following the crowd. So, investors are part of networks with vast exchanges of information regarding economic trends (i.e. investors pay attention to stock market indices, listen to market/economy analysts, subscribe to financial magazines, etc.), and one method of avoiding regret when investing is to buy popular stocks that many others believe to be “good” stocks.
Another example of information cascading in investing has to do with the human error of valuing recent economic trends/opinions/information over historic or “older” information/trends. “Recent” information is cascaded throughout networks, and people sometimes make the error of trusting this information more than historical data. These are just a few examples of some behavioral finance topics relating to networks.
Source: https://www.investopedia.com/articles/05/032905.asp
Source: https://www.investopedia.com/terms/e/efficientmarkethypothesis.asp