Risk In Investment
Behavioral Finance and the Efficient Market Hypothesis are essential aspects of the financial world, especially when making investments (Gill & Bajwa, 2018). Investors need to consult the two before buying stocks so that they can make the right choices. The following are terms that are used in Behavioral Finance and the Efficient Market Hypothesis.
Rational: according to Webster, it is relating to, based on, or agreeable to the reason (Merriam-Webster, n.d.). In Behavioral Finance, the investors’ decisions determine whether their investment bares fruits or not. Rational decision making can be defined as a structured process that an individual takes when making a decision. Rational decision making is based on facts which are acquired after one carries out an analysis of the situation to determine the strengths, weaknesses, opportunity, and threats that exist if they make a particular decision. Rationality is based on logic and not emotions. It ensures that the decision made is not reached in a rush, panic mode, or speculation; instead, it is reached after considering all the possibilities. Rational decision making enables the investor to invest in the right place where their returns will be positive rather than invest in speculation buying stocks at a high and selling them at a low price due to panic when there is a shift in the market.
Anomalies: according to Webster, it is something different, abnormal, peculiar, or not easily classified (Merriam-Webster, n.d.). In the efficient market hypothesis, there are two types of anomalies that might occur that is the pricing and market anomalies. When investing in stocks using some model or theory, one should consider these factors as, at times, the models are not always correct. Anomalies can be defined as the occurrences in the financial world that even the efficient market hypothesis cannot explain. An event that goes against the assumptions that a model had made and proves that the model’s prediction is not practical is an anomaly. For example, when a company that is trading at low price/ earnings is expected to have low returns generated, but an anomaly occurs, and the firm makes high returns. This occurrence contradicts the model that relates low P/E to moderate gains.
Reference
Gill, R. K. & Bajwa, R. (2018). Study on Behavioral Finance, Behavioral Biases, and Investment Decisions. International Journal of Accounting and Financial Management Research, 1-14.
Merriam-Webster. (n.d.). Anomaly. In Merriam-Webster.com dictionary. Retrieved June 11, 2020, from https://www.merriam-webster.com/dictionary/anomaly
Merriam-Webster. (n.d.). Rational. In Merriam-Webster.com dictionary. Retrieved June 11, 2020, from https://www.merriam-webster.com/dictionary/rational