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Investment Theory, Rational and Irrational - Essay Example

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Man is a rational animal, proclaimed Aristotle. While we may be rational, we are yet animals and not robots. In most of the choices we make throughout our life, in fact, irrationality seems to be more reflected in our decisions than rational calculated thinking…
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Investment Theory, Rational and Irrational

Download file to see previous pages... For example, a man may instantly fall in love with a woman and propose to marry her, solely moved by the physical beauty of the woman; but this same man wouldn't invest in a company solely inspired by looking at the rich and luxuriant office premises of that company. He would definitely make further enquiries before he decides to take any step. In economics, or while making any kind of profit and loss decisions in general, we see men at their rational best. Nonetheless, human beings are still good old Homo Sapiens and the much anticipated rise of Homo Economicus never really took place. We make mistakes, we come under the sway of our emotions, we give in to our momentary whims often enough and later come to regret them as often enough. There are differences between person to person of course. Some of us are more intelligent, practical, cool-headed and experienced while arriving at decisions, while many others may not be as rational and practical. All in all, though, there has been found out to be a significant degree of irrationality and inconsistency at play when people make economic decisions. A hybrid branch of economics and psychology called behavioural finance has evolved to study the element of irrationality in the process of decision making; it endeavours to better understand and explain how emotions and cognitive errors influence people when they are making investment-related or other kinds of monetary decisions. But, in fact, behavioural economics consists of theories and empirical investigations into human response to risk, and as such its insights are relevant to any field where decision making is involved and a significant aspect of risk is present.

A basic, and almost commonsensical, finding in this field of study is that people tend to be generally more risk-averse than generally thought of. In 1979, Daniel Kahneman and Amos Tversky propounded their "Prospect Theory," studying human behaviour in relation to risk. In essence what they have found out was that, contrary to the dictates of logic that were taken for granted in the standard expected utility theory of neo-classical economics, people placed different weights on gains and losses and on different ranges of probability. Translated in simple terms, this means that individuals are generally much more distressed by prospective losses than they are happy by equivalent gains. To give a more concrete measure to this rather subjective tendency, some economists have arrived at the conclusion that the difference is almost twice, i.e., people perceive the loss of 1 twice as painful as the pleasure derived from the gain of 1. But there is an interesting twist to this observation. It has been found that faced with a sure gain, individuals become risk-averse, while faced with a sure loss they become more willing to take risk. For example, between a situation of winning 10 for certain, and winning 20 or nothing each with a 50% chance - it has been shown that most people would go for the former. In a real-life situation, faced with a sure gain of 10, people become risk-averse and are less likely to go for 20 with only a 50% ...Download file to see next pagesRead More
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