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Flawed Thinking of Investors

Investors are the most important constituents of any corporation. They are the owners and, at the same time, their fickle-minded behavior can play havoc with stock prices in any stock market. They are the core activists in any stock market.

The stock prices are said to be the real value of any company. But, the stock price is never a true reflection of the true worth of a corporation. It is function of the perceptions of the investors.

Traditional finance theory states that markets are efficient and that investors make rational decisions to maximize profits. The Prospect Theory also supports this concept of traditional economic assumption. It means that “Decision making” aims at “Profit maximization”.

However, the recent developments in the area of finance and the new school of thought as propounded by the Behavioral Economic theory believes that, the assumptions under the conservative finance theory may hold true in the long run, but in short run, markets are not efficient and people do not make rational decisions either.

People as investors have a mind and a heart, but they do not always make decisions only out of their mind. When they involve their heart in decision making, such decisions are emotional and may not be rational. Their actions are mostly driven by their emotions, which do not necessarily possess the motive of profit maximization. It may be represented by the way of “Decision Making + Emotions=Uncertainty about profits/returns”. The study of this phenomenon is popularly known as Behavioral Finance.

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