By Somali K Chakrabarti
For an investor, the pain of selling a stock at a loss far exceeds the pleasure of selling the stock at an equal amount of gain.
Strange but true!
Such behavioral aspects of investing and many more are brought out in the study of behavioral finance, that was introduced in the late 1980s, owing to anomalies in stock price prediction by the two main existing theories of academic finance, i.e. Modern Portfolio Theory’ and ‘Efficient Market Hypothesis’.
According to the ‘Efficient Market Theory’, put forth by Eugene Fama, financial markets are believed to be efficient and investors are understood to make rational decisions. Further, market participants are supposed to be sophisticated, informed and known to act only on available information. Since market participants are believed to have equal access to information, it is implied that stock prices always reflect the best information about fundamental values of the stocks. According to the efficient market theory and Capital Asset Pricing Model (CAPM) the price of a stock is the Present Value (PV) of all the entire future earnings of the company i.e. the future dividend paid by the company.
The ‘Modern Portfolio Theory’ pioneered by Harry Markowitz suggested that an investor can maximise returns by holding a diversified portfolio of assets with different levels of risk.
However stock prices were found to exhibit more volatility than efficient market hypothesis could explain. Read more