Why Are Markets Not Rational?

Here is a short video explaining why markets are not rational at times. Anchoring is one of the most common mistakes people make in investing. 

Transcript of the video follows below.


Behavioral Economics combines insights from psychology, judgement and decision making with economics to generate a more accurate understanding of market behavior.

Traditional economic and financial theory assumes individuals act rationally and consider all available information. These assumptions are frequently untrue.

Behavioral economics seeks to explain why people make decisions that are irrational.

When people are faced with an uncertain situation that demands time and thinking effort (yes thinking saps energy!) researchers have found that people face difficulty making rational choices. Personal biases can influence decision-making processes and have been found to drive individuals to make sub-optimal decisions.

 

Let’s start with the first bias – Anchoring Bias

Here is the stock chart of a company from 2010 to 2015

If you purchased a stock at 100 and the price doubled to 200 in 6 months. Would you buysell or hold?

 

Within a year the stock has moved up to 300 or 400 or 500, if you had sold at 200 would you have bought it back again? Unlikely? Why? Our initial cost of 100 and the price we sold at 200 are our anchors. Is there a way we can ease the memory of what price we paid or sold it before? This is the problem we are attempting to solve when we allocate a stock in the portfolio.

 

The punch line the same stock is 2500 today!

 

When we make decisions, we often use an anchor or focal point as a reference. Humans tend to put a heavy reliance on this initial information. This affects other areas of our lives.

 

At times, markets are not rational because human participants are not rational. Behavioral economics acknowledges this. Investors should be aware of these biases when it comes to investing

 

 

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