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Investor Behavior in the Stock Market

If you were asked if you thought investors always acted rational in their investment styles, what would be your answer? Many different theories have been given concerning the stock market and if it is actually an efficient market. If investors acted rationally all the time, then you would think that the market does act efficiently all the time. The interesting thing is that investors do not act rational all the time.

In 2001, Dalbar, a financial-services company, released a study they had completed on investor behavior. They found that in the 17 year period that included data up to December, 2000 investors actually did worse than the S&P 500. The average investor only made a 5.32% return on their money during this period while the S&P 500 increased by over 16%. This would indicate that it would be better to invest in a S&P 500 index fund and leave the decision making out of the mix.

Research was done as to why the average investor did not do well in their stock trading strategy. Several different reasons were found to be the cause.

Emotions played a major factor in how an investor did on their investment returns. This was given the name "investor regret". If an investor purchased a stock and it went down, they were unwilling to let it go. They were unwilling to admit that they had made a mistake. They did not realize that they could go further if they would only admit their mistake and move on to a winning investment. The flip side of this is when an investor does not act on their research and does not buy a stock and then watches that stock soar. This can be hard on the nerves.

Mental Accounting is the process of placing different events into different compartments. This mental accounting affects our behavior in relation to our investments. If an investor has watched an investment go up $200.00 and it is now only up by $100.00, that investor will not sell the stock. They just can not walk away from that $100.00 even though it was never theirs.

Anchoring is where the investor pins their expectations on historical prices. They expect that the market will continue to go in the direction it is moving and refuse to acknowledge anything different. They anchor their belief on past performances. Stock markets do have ups and downs and they do not always act as either a bull or bear market. The trick is to be willing to admit that a shift has occurred.