Stocks and Psychology
A good investor must understand the role that emotions play in investment decisions.
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A good investor must understand the role that emotions play in investment decisions. This area of finance is called behavioral finance and attempts to explain why people make irrational financial decisions. The goal is to understand how emotions, cognitive biases, and social influences can affect individuals' investment decisions and ultimately market prices.
A key aspect of behavioral finance is the distinction between short-term and long-term prices.
Short-term stock prices are often driven by investor sentiment, market trends, and speculative behavior. These prices can fluctuate rapidly and do not always reflect the true value of an asset. Short-term mispricing refers to periods of irrational exuberance or panic in the market. During these periods, which can sometimes last for years, stock prices can become disconnected from underlying fundamentals, based more on emotion than logic. The subprime crisis of 2007 was one of the most devastating economic events in recent history. In 2005, some smart investors saw the warning signs in the housing market and took action to protect themselves from the impending crash. However, the mispricing did not collapse as quickly as many expected. The bubble continued to inflate for several years as lenders continued to issue subprime mortgages to borrowers with poor credit. This delay in the market correction ultimately led to a worsening of the crash in 2007.
Long-term stock prices, on the other hand, are more influenced by fundamental factors such as company performance, industry trends, and economic conditions, with stock prices converging toward their intrinsic (true) value over time. Rational investors focus on the long-term prospects of an investment rather than short-term price fluctuations. In this process, mispricings are corrected as market participants reassess the fundamentals of companies and adjust their valuations accordingly.
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