Can behavioural finance help you make better investment decisions? Yes, according to Steve Foerster, professor of finance, Ivey School of Business, The University of Western Ontario. He was speaking at the 2010 Investment Innovation Conference in Phoenix Arizona.
He talked about how investors and practitioners put their faith in the Capital Asset Pricing Model for three decades believing that markets behave in rational, consistent ways. The financial crisis, however, has shattered their belief in efficient market theory. “History shows that markets don’t move rationally,” said Foerster who noted examples in shitory like the South Seas Bubble and the irrational exuberance that fueled the Tech Bubble. “We are all prone to irrational decisions,” he said and as a result stock prices don’t always reflect their instrinsic value.
So how can plan sponsors use this knowledge? Forester believes investors should not use behavioural finance theory to identify opportunities – instead, they should use it to identify red flags in the market. Specifically, the stocks people should avoid are those that have recently doubled in value. Foerster said investors overreact to these and, therefore, they are not good investments: “Avoid stocks that have recently doubled in value, especially if you have an investment horizon of one to four years,” he said.