Efficient investment market theory states that as all investors have access to exactly the same information at the same time, there are many well resourced participants, therefore it is impossible for investors to do better than the market.
Efficient market theory would work it if weren't for one thing - there is human involvement in the investment making decision progress and humans are hard wired differently and have many different personal biases and traps.
Here were begin examining some common investor short comings in a bid to help you reduce the number of mistakes made as an investor.
1. Confirmation Bias - as intelligent people we believe that we make decisions based on researching facts and analysing information. We tend to suffer from Confirmation Bias where a decision is made and then information is sought from sources that support our pre-conceived ideas.
2. Loss Aversion - Humans are highly loss averse. Studies have been done that show people are two and a half times more sensitive to loss than they are to gain. Suppose you had a choice where you can accept a sure $500 or you can face 50-50 odds that you will either win $1,000 or nothing at all. What would you do?
Or suppose that you are in the unfortunate situation where you have lost $500. However instead of accepting this loss, you can face 50-50 odds that you either lose $1,000 or you lose nothing. How would you react? In a study more than half the students in this situation would take the chance of losing $1,000 instead of accepting a sure loss of $500. Phychologists emphasise that although people generally behave conservatively when it comes to risk, they are much more willing to take risks when they think they might be able to avert a loss.
3. Framing - is a cognitive characteristic in which people tend to reach conclusions based on the 'framework' within which a situation was presented.
This behaviour can result in making poor choices such as selling winning investments rather than realising a loss on a poor investment.
For example consider a community preparing for the outbreak of an unusual disease which is expected to kill 600 people.
A) If Program A is adopted, 200 people will be saved
B) If Program B is adopted, there is a 33% chance that 600 people will be saved, and 67% chance that no people will be saved.
Which Program would you choose?
Results from a conference where this was asked showed that 72% of respondents would choose Program A, despite the fact that the outcome of both Programs are the same.
4. Anchoring - the use of irrelevant information as a reference for evaluating or estimating some unknown value or information. When anchoring, people base decisions or estimates on events or values known to them, even though these facts may have no bearing on the actual event or value.
In the context of investing, investors will tend to hang on to losing investments by waiting for the investment to break even at a the price at which it was purchased. Thus, they anchor the value of their investment to the value it once had, and instead of selling it to realise the loss, they take on greater risk by holding it in the hope it will go back up to its purchase price.
5. Over-reaction and Availability Bias - One consequence of having emotion in the stock market is the overreaction toward new information. According to market efficiency, new information should more or less be reflected instantly in a security's price. For example, good news should raise a business' share price accordingly, and that gain in share price should not decline if no new information has been released since.
Reality, however, tends to contradict this theory. Oftentimes, participants in the stock market predictably overreact to new information, creating a larger-than-appropriate effect on a security's price. Furthermore, it also appears that this price surge is not a permanent trend - although the price change is usually sudden and sizable, the surge erodes over time.
Winners and Losers - example
In 1985, behavioral finance academics Werner De Bondt and Richard Thaler released a study in the Journal of Finance called "Does the Market Overreact?" In this study, the two examined returns on the New York Stock Exchange for a three-year period. From these stocks, they separated the best 35 performing stocks into a "winners portfolio" and the worst 35 performing stocks were then added to a "losers portfolio". De Bondt and Thaler then tracked each portfolio's performance against a representative market index for three years.
Surprisingly, it was found that the losers portfolio consistently beat the market index, while the winners portfolio consistently underperformed. In total, the cumulative difference between the two portfolios was almost 25% during the three-year time span. In other words, it appears that the original "winners" would become "losers", and vice versa.
Investing is both a science and an art. Keeping controls of ones emotions plays a large part in the outcome.
"Individuals who cannot master their emotions are ill-suited to profit from the investment process"
"The investors chief problem, and even his worst enemy - is likely to be himself"
"To achieve satisfactory investment results is easier than most people realise, to achieve superior results is harder than it looks"
Benjamin Graham (attributed to teaching Warren Buffett)