BEHAVIORAL FINANCE- HERD MENTALITY
Ever wondered why does the stock market crash all of a sudden? why do all stocks turn red or why there is a bear rally or a bull rally? to answer all your questions today i am writing an article on investors psychology or Behavioral Finance. Behavioral finance is the study which includes important psychological and behavioral variables involved in investing in the stock market that provide opportunities for smart investors to profit.
When a stock becomes hot without any significant change in the company fundamentals or is in a huge demand the psychological aspects come into the picture. They therefore might short the stock in the , believing that eventually the psychological will burst and they will profit.the markets are not efficient. More often the inefficiency is caused by the different investors perspectives which also brings about the change in demand and supply of shares which causes the markets to either fall or rise. These inefficiencies are necessary in the market. Behavioral finance study helps to understand these price movements.
How It Works/Example:
Suppose a lawsuit is brought against a construction company. Investors know that when this has happened before, the share price of the construction company has fallen. With this in mind, many investors sell off their holdings in the company. This selling results in the further decline of the security's value.
This results into a rhetoric cycle where investors of other construction companies also selloff in fear of a similar condition with their company too. This results into a fall in the stock price of these companies too. So such actions are infectious and viral if caught with one company of a particular sector other companies may also face a reaction in the same sector.
One important criteria of behavioral finance is the herd mentality. The word suggests that herd mentality is the uniform thinking of all investors. herd behavior, which is the tendency for individuals to mimic the actions (rational or irrational) of a larger group. Individually, however, most people would not necessarily make the same choice. It means if a particular group is selling off the whole market will behave like that. These type of people get carried away and lack of individual decision-making or thoughtfulness, causing people to think and act in the same way as the majority. The decisions are not taken by them but are influenced by others. Such type of behavior is usually seen during peak rallies either a bull or a bear. sometimes this behavior can be profitable and sometimes dangerous. It happens that when the investors should sell and exit they actually enter thus creating a bubble. This happened during 2000’s Dot-Com bubble.
There lies an opportunity for the smart investor in such situations by not falling into the trap and making sensible investment decisions by correctly surveying market sentiments so whenever you notice an usual behavior in the market or in the stock just keep an eye over the mentality factor.Herd mentality is very much prevalent in the stock market. just because few investors buy or recommend a stock others will also buy the stock without applying their own logic to it.that is why we see those stock bubbles or a euphoria rally or a bust in the market
Herd mentality is just 1 factor of behavioral finance and its a deep study too.there are many other factors concerning behavioural finance.
P.S – reference is made to other websites like http://www.investopedia.com/university/behavioral_finance/behavioral8.asp