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SPECIALIST ARTICLE | 29. July 2022

BEHAVIORAL FINANCE

Three different phases in the investment process

In times like these with high volatility, investors often ask themselves the same questions: Should I react? If so, how? Is this an exaggeration? Irrational decisions are often the result.
This is where the thesis of "behavioural finance" comes into play, which, in contrast to the efficient market hypothesis, holds that markets are not completely efficient at all times. Psychological and social factors also influence the supply and demand of shares. This attempts to explain market anomalies and distortions.

Three different phases are defined in the investment process:
1. information perception
2. information processing
3. decision-making

In each of these phases, phenomena can occur that prevent or disrupt the investor's rational behaviour. In the following we will describe some phenomena
that can typically be observed in practice.

Information perception
Risk perception or the perception of risk is strongly dependent on the personality of the observer and on personal experience. This can lead to a strong discrepancy between the actual perceived risk and the subjectively perceived risk. In good market phases, investors tend to take more risk and vice versa. If the information on risk appetite does not match the actual subjective perception, this often leads to undesirable results. Investors then tend to make short-term interventions in the long-term strategy in the event of market fluctuations.

Selective information perception can also have an undesirable influence. This is understood as the conscious or unconscious neglect of information. Investors specifically look for information that confirms their decision and ignore contradictory information. As a result, this leads to misjudgements and wrong investment decisions.

Information processing
In the second phase of information processing, there is a danger that investors overestimate themselves. Information that contradicts their own beliefs is given less weight. Often, the belief in an information advantage creates a tendency to make as many transactions as possible, which often only leads to higher costs.

Decision-making
The third and final phase is the decision-making and thus the actual action of the market participant.

The best-known phenomenon in public is the socalled herd behaviour, which occurs when a large number of market participants base their decisions on the decisions of other market participants. Feelings such as joy or fear can turn into more extreme states such as euphoria or panic if they are appropriately reinforced.

An overreaction is triggered primarily by negative information. Such behaviour, which is often also associated with strong emotions such as panic, is reinforced above all by mass phenomena such as herd behaviour and can lead to serious market distortions.

In contrast, the optimism effect causes investors to be fundamentally too optimistic about future scenarios. This optimistic attitude of market participants is often the basis for speculative bubbles.

A systematic investment process is the best way to protect oneself from the behavioural patterns described and their negative effects. The basis is a longterm investment strategy tailored to the risk profile. Independent investment controlling and reporting ensure that this strategy is implemented consistently, independent of short-term market fluctuations, and that decisions are made on an objective information basis.

LMM COMPASS

With our newsletter we provide information about the current situation on the financial markets, current investment topics and LMM.

Vaduz
LMM Investment Controlling Ltd.
Zollstrasse 32
9490 Vaduz
Liechtenstein
T +423 235 07 90
info(at)lmm-ic.com
Switzerland
LMM (Schweiz) AG
Schochenmühlestrasse 6
CH-6340 Baar
Switzerland
T +41 43 222 40 06
schweiz(at)lmm-ic.com
Germany
LMM Investment Controlling GmbH
Nextower 29. Stock
Thurn-und-Taxis-Platz 6
D-60313 Frankfurt am Main
Germany
T +49 692 573 751 23
frankfurt(at)lmm-ic.com
Austria
LMM Investment Controlling Ltd.
Vienna Branch
Tuchlauben 3
1010 Vienna
Austria
T +43 1 512 26 47
wien(at)lmm-ic.com
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