Investors or advisors focus on customer needs to identify the best investment op

Question

Investors or advisors focus on customer needs to identify the best investment options while considering opportunity costs and market uncertainties. Investors often react in an irrational manner and respond promptly to market events or information. If investors base their decisions on behavioral finance, behavioral psychology, or heuristics and biases, it may result in investment misperceptions rather than objective information filtering. Acting in this manner will cause investors to make irrational decisions. Discuss how efficient market hypothesis, heuristic behaviors, and biases shape the investment decision-making process in formulating an objective portfolio.

Explanation / Answer

EMH- Efficient Market Hypothesis is a theory that states that it is impossible to beat the market, because in an informationally efficient market, securities are generally trading at the proper price neither undervalued nor overvalued. As the market is efficient in updating the securities as soon as any news comes for that security.

But sometimes it is not so, history proves that sometimes while analysing the financials of a company it is found undervalued or overvalued and the market participants(advisors) act on them and gradually push them to their correct price. That is what advisors look for while selecting securities for a portfolio.

They also overcome behavioral biases such as cognitive bias and emotional bias I.e. they do not act rapidly or irrationally on an information, they analyse it carefully by going through all the materials available and then jump to the conclusion. Emotional bias is when an investor gives more value to the asset he holds and lesser value to the one he doesn't and hence ends loosing money while advisors with the aid of proper training and education are more efficient in overcoming these biases.

Heuristics are simply speaking thumb rules or cognitive biases that are used in solving problems more quickly but lead to behavioral biases. They rely on past experiences, stereotypes etc. Sometimes they help in selection of security but as per Dow Jones theory market tends to behave as a drunkard, heuristics may also sometimes lead to wrong selection of securities.

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