Why do traders behave the way they do?

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Behavioural Finance

In many of our previous editorials, I mentioned that what makes the market is not just supply and demand. It is all about us. I need to mention early in this editorial, traders and many investors are irrational. We are driven by our “fear and greed”.

On one hand we have the analysts that will only look at the fundamentals factors that they believe will help them determine the value of a stock. They also believe that the price of a stock will follow its intrinsic value.

On the other hand we have the technical analysts that will only look at the technical factors (charting) that will determine their stock price forecast. They believe that previous price trends will help them see future trends.

Recently a new factor has arisen where now it is believed that the irrational behaviour of traders and investors may push the price of a stock up or down beyond its intrinsic value.

So the new science that yours truly is currently covering in his attempt to finish his Masters of Finance at Bond University is known as “behavioural finance”. It tries to explain market anomalies (irrationalities) by attempting to understand why traders and investors behave in a particular way. This will attempt to understand their characteristics (if that is possible).

I recently covered the efficient market hypothesis and we can now say that behavioural finance studies will contradict it. We begin to understand that the market is not as efficient as researchers earlier thought.

The market is volatile. The market does not necessarily move just because of new information appearing.  Other factors that are irrelevant to a stock may push the stock price up or down. So contrary to previous theories (hypotheses), even though a stocks intrinsic value may not have changed or any new information related to the stock may have appeared we may see the stock price moving irrationally.

Going back to the dot com bubble and the subsequent crash, the efficient market theory is really hard to accept. We have come to accept that irrational behaviour is now common place in trading and investing.

Importance of Losses Versus Significance of Gains
Here is question that attempts to answer the psychology of most traders: If I offer you 2 dollars guaranteed versus 4 dollars on the flip of a coin, with 50% probability of success, what would you chose?

Would you take the $2 for sure? You will probably take the $4 with a probability of 50% chance.

Here is the same question that attempts to add further understanding into the psychology of most traders: If we offer you 200 dollars guaranteed versus 400 dollars on the flip of a coin, with 50% probability of success, what would you chose?

You would most probably take the $200 guaranteed.

The statistics are the same but your view on return has changed because of what you perceived to be more important as return versus the risk. Didn’t you?

Here is the same question again that attempts to add further answer into the psychology of most traders: If you lose $200 guaranteed, OR on a flip of a coin, you incur a loss of $400 or lose nothing.

You probably choose the coin choice because of the probability of no loss even though the loss could by $400 with 50% probability.

People tend to view the possibility of avoiding a loss as more important than the possibility of greater gain.

The priority of avoiding losses holds true also for investors. Just think of BHP shareholders who watched their stock’s value plummet from nearly 50 dollars in 2008 to nearly $20.

No matter how low the price drops, investors, believing that the price will eventually come back, often hold onto stocks.

Tomorrow I will do part 2 and cover the Herd mentality.

Stay tuned!