Traditional market theories explain how traders' behaviour affects supply and demand, which influences asset prices. One of the foundations for these theories is that investors trade rationally, according to certain assumptions.
The problem is that when more and more investors have access to the financial market there are also investors that do not behave according to these assumptions. Instead they behave according to their own rules or according to surrounding information, hence becoming so called irrational investors. One of the key characteristics of these irrational investors is that they are subject to emotions involving markets and transactions, while rational investors analyse and make decisions only according to fundamental theories.
Some theories consider investors to be irrational to everyone that does not make investment decisions based on “traditional” economical theories - not considering technical analysis as an economical theory.
In a behavioural economy there are many effects explaining on which foundations individuals make decisions, some of which are described below:
Bandwagon effect:
Individuals make decisions according to the expectations of people surrounding them
The Bandwagon effect is actually very common behaviour, observable even on a daily basis. This effect relates to situations where individuals make decisions according to the majority of people surrounding them, and often not according to their own beliefs. As mentioned before, this is a common effect used, between others, in consumer economics trying to explain why people buy something because it is trendy, even though for the consumer it’s costly and is not a necessary item, i.e. it is irrational. For markets, this effect may also have very serious consequences, due to unconfirmed information (gossip, speculation, or other types of information) which makes prices move very sharply.
Herd behaviour:
Sometimes individuals make unplanned decisions according to group decisions
The herd behaviour is very similar to the bandwagon effect, but rather describes the actions (behaviour) of individuals in a group. The main finding here is that individuals can act as a group without a planned direction, which is observable during market crashes or market bubbles when investors together increase the effect of a crash or a bubble.
Loss aversion - Disposition effect:
Individuals prefer to cut profits and keep losses
This behaviour exists when investors have a tendency to sell assets when prices have increased, but will keep the portfolio assets that have decreased in value. What this means is that investors are less willing to recognise their losses than their profits, which leads to extended losses in the portfolio.
Focusing effect:
When there is little information available, investors tend to rely on information with small significance
This effect occurs when investors tend to rely too much on one piece of information instead of the general situation. This may have different reasons, for example one situation is when investors are suffering losses, they want to believe that positive information (rather insignificant in reality) will change the price direction and they will start to profit.
Optimism bias:
Investors tend to be too optimistic
This is the process when investors tend to be too optimistic about the result for planned actions. Usually this means that investors tend to overestimate the likelihood of positive events and underestimate the likelihood of events with negative consequences.
Ostrich effect:
Some investors assume the denial posture related to negative events
This is behaviour often seen in investors with little experience, and it is a simple denial of negative situations. In this situation, investors are so “goal-focused” that they do not accept (deny) the existence of current or future negative events.
Overconfidence effect:
When taking profits investors tend to be overconfident
In a way this effect is somewhat related to the optimism bias, but in the case of the overconfidence effect investors believe that their judgement of making decisions is high, compared with their actual accuracy. This effect is even more observable when confidence rises, which may result from obtaining some (higher than usual) profits.
Regret theory:
Sometimes investors regret not having made a transaction during prices peaks, so they will keep positions open in order to make up for “opportunity costs”
The regret theory takes into consideration the reaction of individuals having realised they have made a mistake in judgment. For example, sometimes investors regret not having closed an open position at a certain price, that has turned out to be a market extreme In such a case, it is a typical reaction to postpone the decision of closing the transaction, in order to make up for lost “opportunity costs”.
The typical consequence of such an approach is that the investor tends to miss the opportunities that he or she would take in other circumstances, and as a result, achieves a worse result than in normal circumstances.