Behavioural Finance - Essay Example

It is very clear that some of the participants in the market do not make rational decisions which translate to mistakes. However, astute market players get the chance to capitalize on such mistakes. For instance, a rational investor can take the decision to buy when there is market crash resulting from speculative behavior (Mussweiller & Schneller, 2003, p. 124). Given a risk-adjusted basis, rational investors can beat market performance in a consistent manner. According to the perfect market hypothesis, prices reflect the full information about the market.

This has the implication that an investor cannot beat the market unless he or she has inside information. A number of indices have been created with the aim of mimicking market performance. Research studies indicate that index funds account for almost 10 percent of the U.S. stock market capitalization and 60 percent of the money flowing into mutual funds. Despite the increasing euphoria towards passive management, there is active management which has enabled investors beat market bearing returns.

Behavioral finance insists that investors are irrational in their decisions and that it is easy to partly predict future performance of stocks using their past performance. Careful analysis of the past trends of the tocks has the advantage of making it possible to outperform the market (Mulino, Scheelings, Brooks & Faff, 2009, p. 50). Rational investors can outperform because there exists inefficiencies in the capital market which create investment opportunities. Rational investors outperform the market because irrational investors often find themselves in the bottom part of the distribution pattern.

There is some level of disconnection between stock performance and stock market valuation. The existence of irrational investors has resulted in the markets being driven by emotions rather than logic (Dreman, Johnson, MacGregor & Slovic, 2001, p. 127). However, research studies indicate that logic often triumphs over emotions. Irrational investors tend to lose while logic investors record gains. Most of the investors in the market do not bother to look at the fine details of their investment portfolios.

Instead they look for information such as who are investing in the same portfolio and this has the negative effect of encouraging wrong decisions. There are a number of situations that a rational investor can exploit and record superior performance that the market. Theoretically, this is possible even though no investor has ever recorded consistent returns above market expectations (Statman, Fisher & Anginer, 2008). First, a rational investor can do a comprehensive homework and identify small cap stocks that in most cases are not well followed.

Such stocks are often ignored by equity funds because of the fear of high risks associated with small companies. Furthermore, such companies are not well known in Wall Street and this makes it possible for most of the investors to ignore them (Caginalp, 2002, p. 73). A rational investor can identify such companies and analyze their prospects for superior returns. The small cap firms have a potential of recording higher returns than the market because their true value has not been influenced by speculations.

Second, the market sometimes overdoes its pessimism for a number of individual companies as well as certain sectors (Bruce, 2003, p. 125). The situation