Rational or Irrational?

Traditional Finance Theory assumes that markets are efficient and that market participants are rational in their trading / investing behaviour.

Behavioural Finance, on the other hand, is based on the theory that market participants can have psychological / behavioural biases that can trigger less than rational trading / investing  behaviour:

Lets look at a few of these behavioural biases:

Traders / Investors:

1.  Overestimate their ability and the accuracy of the information that they have.
2. Assess situations based on "past experience" (superficial characteristics) rather than the underlying current reality.
3. Overstate the probability of an event reoccurring because it has been a recent experience: after the crisis of 2008, many expected a "double dip" in 2010 and 2011.
4. Allocate wealth into separate compartments instead of viewing it as one large pool: "house money", "retirement money", "education money", "risk money", etc.
5. Fear making decisions that will lead to regret : selling losing positions because "someday" they might return to profitability.

And there are many more....

• Active managers wish to exploit these irrational tendencies when markets create "value" through prices that are skewed to reflect less rational expectations.
• In other words, market timing can possibly present opportunities.

A possible conclusion?

Perhaps a combination of  a portfolio of "core" indexes (with ETF's) and smaller portion dedicated to more active, tactical management.

As always, this strategy should be approached in the context of your long-term goals and objectives and the level of risk that you are comfortable with. 

Back to Risk Adjusted Returns:

(Tuesdays blog: When Boring Is Good!)

The views expressed are those of the author, Scott Tomenson, a Raymond James Financial Advisor, and not necessarily those of Raymond James Ltd. It is provided as a general source of information only and should not be considered to be personal investment advice or a solicitation to buy or sell securities. Investors considering any investment should consult with their Investment Advisor to ensure that it is suitable for the investor's circumstances and risk tolerance before making any investment decision. The information contained in this blog was obtained from sources believed to be reliable, however, we cannot represent that it is accurate or complete. Raymond James Ltd. is a member of the Canadian Investor Protection Fund