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Behavioral Finance

In behavioral finance investment decisions are based on investors’ behavioral patterns and the way they react to the news. Various studies have shown that there is a pattern that links investors’ decisions and their psychological behavior (Nevis 2003). The theory is based on analyzing cognitive, social, and emotional factors that assist in understanding the economic decisions of the investors. Unlike in efficiency market theory where investors will base their investment decisions based on rational, and where investments match with the fundamental value of the assets, behavioral finances basis its argument on the fact that some agents do not use this rational in making their investment decisions. Research has shown that these irrational decisions have a big impact on the market (Barberis, 2003). Most of the assumptions in traditional investment theories have been criticized as they are not consistent with the reality of the individual investor’s decision-making. Traditional investment theory has always assumed that an individual investor will make an investment decision based on the information that is received on a certain investment, this being the rational decision to make, however, this assumption has been proved wrong (Barberis & Thaler, 2003).

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In behavioral finance the agent should define a strategy based on the investor’s point of view and main goal, to gain wealth from the investment. From this point of view, the individual’s specific goals should be analyzed in terms of time (long term, short term middle term). The agent should then gather as much information on each investment but keeping in mind that current performance is not necessarily an indicator of future performance. The standard investment method had all along assumed that past performance is an indicator of future performance as the users of this method had always relied on the assets expected returns and standard deviations in analyzing the how to meet the investors goals. The behavioral theorists have criticized this method arguing that individual goals are based on an investor’s psychological behavior (Nevins, 2003). The behavioral finance theorists have argued that investors are not necessarily risk averse but instead, they are loss averse. It is therefore important for the agent to minimize not risk but the possibility of an investor incurring losses in their investments. The M&M agent should analyze the risks involved in these portfolios and compare it with the individual investor’s willingness to risk. Each investor’s goals should be separated and linked with the individual investor’s strategy and specific goal. The M&M agent should pick several investment portfolios and segregating them depending on the clients’ goals, which are short-term, middle term or long term. An analysis of any constraints that the client may have should be done. If an investor has more than one goal, then the agent will need to have different strategies for different goals, which means maintaining separate accounts for each goals and thus making decisions based on each account. This will be in line with retaining the investors’ preferences.

In order to achieve all these different goals for the investor the agent should then make sure that the investments are diversified. In diversifying the investment portfolio, any assets that are doing poorly will be balanced by those which are being profitable at any given time. Diversification is used as a way to minimize risks.

Another strategy recommended by behavioral theorists is for investors to move away from bias where the investor reacts strongly to the newly released information believing that the information received will impact on the value of the investment. This has always led to overconfidence which in the standard investment methods has led to many losses for the investors. The strategy that M&M should adopt should be investors’ specific goal oriented which should also be loss averse.

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