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 long
term, believing
that eventually the psychological bubble 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.
HERD MENTALITY
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