Investing and trading stocks and other securities is more than using formulas and theories to make decisions, as if it was an exact science. Because investors are not computers, their decisions will also be based on their emotions or personal biases. In other words, subjective behavior is as much a part of an investor’s decision as is a rational objective theory.

Rational Thinking

Behavior trading and behavior economics follows the thought that people are not as rational as they would like to think. From the beginning, theories were developed from observations and survey results, but the theories do not take into consideration that investors are people who react on instinct and/or emotions.

Themes

There are three main themes to behavior trading. First, investors, as human beings, make decisions by rules of thumb and not strictly by rational analyses. Second, the way a situation is framed will influence the decision. And third, any attempts to explain market outcomes that are observed are contrary to rational expectations and market efficiency.

All the theories or historical markers cannot deter an investor if he is averse to losing money or gets caught up in the hype of a hot stock. The dotcom boom and bust was as much about behavior trading as it was rational theories.

Behavior Gone Wild

One of the best examples of behavior trading came when the stock market crashed in 1929. As the market slid downward, investors began to panic. Granted, many of the theories that are in place were not in place in the 1920s; however, there were theories available, such as the Dow, which should have promoted rational thinking. However, cooler minds did not prevail. Fear struck investors who envisioned loss of a lot of money. Rational thought was ignored.

In the case of the stock market crash, there was a herd mentality at work, which is one of the tenants of behavior trading. People tend to imitate the behavior of others rather than acting solely in their own self-interest. There is a belief that once someone acts in one way, it is because they have certain information. Investors are just as likely to trade based on what others do as on the indications of theories.