What Is Investing?

Investing is the act of allocating resources, usually money, with the expectation of generating an
income or profit. You can invest in endeavors, such as using money to start a business, or in
assets, such as purchasing real estate in hopes of reselling it later at a higher price.

Concept of Investment
Investment is a conscious act of an individual or any entity that involves deployment of money
(cash) in securities or assets issued by any financial institution with a view to obtain the target
returns over a specified period of time.
 In an economic sense, an investment is the purchase of goods that are not consumed
today but are used in the future to create wealth.
 In finance, an investment is a monetary asset purchased with the idea that the asset will
provide income in the future or will be sold at a higher price for a profit.
Generally, income and expenditure of an individual never equals. If current income exceeds
current desires, people intend to save their surplus. With this surplus they plan to use the saving
in another way. In this connections, individuals may have various alternatives. They can deposit
the money in bank or purchase government or corporate bonds or invest in stocks or contribute
the fund to a provident fund or purchase the real assets like land, building, plants etc. In this way
what people think about the use of saving that is known as investment.
Investment refers to the sacrifice of present financial resources with the view to get additional
benefit in future. Therefore, investment can be defined as a alternative or best use of the saving.
Purchase of real or financial assets is considered as the investment. Such use takes place at
present and almost certain. However, returns are generated in future and that are generally
uncertain. Therefore, every investment involves some degree of risk which occurs due to several
reasons.

Five basic investment concepts that you should know

You don't need to take an economics or finance course to learn how to invest, but it is important
to understand these basic investment concepts.
Difference between corporate finance from investment

Corporate finance deals with the interaction between firms and financial markets while investment
is the interaction between investors and financial markets
You know that putting money aside for the future is important. The words “saving” and “investing”
are sometimes used interchangeably, but when it comes right down to it, we should be engaged in
both to secure our financial future.

Investment Alternatives
While the SEC cannot recommend any particular investment product, a vast array of investment
products exists. Before you make any investment, understand the risks of the investment
and make sure the risks are appropriate for you. You’ll also want to understand the
fees associated with the buying, selling, and holding the investment. 
 What is Behavioral Finance?
Behavioral Finance is the study of the influence of psychology on the behavior of investors or
financial analysts. It also includes the subsequent effects on the markets. It focuses on the fact
that investors are not always rational, have limits to self-control, and are influenced by their own
biases.
Behavioral finance, a subfield of behavioral economics, proposes that psychological influences
and biases affect the financial behaviors of investors and financial practitioners. Moreover,
influences and biases can be the source for explanation of all types of market anomalies and
specifically market anomalies in the stock market, such as severe rises or falls in stock price.

Why behavioral finance came about?

The field of finance is based on 2 rigid assumptions:
 People make rational decisions
 People are unbiased about their predictions of the future

Why should we learn behavioral finance?

 Behavioral finance help you learn about psychological biases

 You can understand how these psychological biases affect your investment decision making
process
 You can see how poor investment decision caused psychological biases affect your wealth
The costs of irrational financial behavior
Behavioral finance acknowledges that investors have limits to their self-control and are influenced by
their emotions, assumptions, and perceptions. These biased and irrational behaviors have real costs.
They help account for the difference between what investors should be earning and what they
actually manage to take home. DALBAR, a financial research firm, has conducted many studies
comparing investors' rate of return against the performance of the market. 

Difference between traditional and behavioral finance

Traditional Financial Theory
In order to better understand behavioral finance, let’s first look at traditional financial theory.
Traditional finance includes the following beliefs:
 Both the market and investors are perfectly rational
 Investors truly care about utilitarian characteristics
 Investors have perfect self-control
 They are not confused by cognitive errors or information processing errors

Behavioral Finance Theory

 Traits of behavioral finance are:

 Investors are treated as “normal” not “rational”
 They actually have limits to their self-control
 Investors are influenced by their own biases
 Investors make cognitive errors that can lead to wrong decisions

 Behavioral Finance Concepts

 Behavioral Finance typically encompasses five main concepts:

Decision-Making Errors and Biases

Let’s explore some of the buckets or building blocks that make up behavioral finance.
Behavioral finance views investors as “normal” but being subject to decision-making biases and
errors. We can break down the decision-making biases and errors into at least four buckets.

Top 10 Biases in Behavioral Finance

Behavioral finance seeks an understanding of the impact of personal biases on investors. Here is
a list of common financial biases.
 Overcoming financial behavioral biases
How can you avoid or remain unswayed by your financial biases? You can't, at least not entirely.
But just knowing that syndromes like these exist will help some. A few other tips: 
 Before buying a stock or mutual fund, decide just how much it would have to go down or up
before you'd sell it.
 Since losses hurt more than gains make us feel good, accentuate the negative when thinking about
saving and investing.
 Keep track of the decisions you made about money, and why you made them. Then revisit them in
a year.
 Try getting out of your bubble: If almost everyone you're exposed to is doing the same thing and
pursuing the same investments, they may of course be right.
 Remember, money is fungible. If you find yourself with funds you didn't expect, take a moment to
figure out where they can do the most good, especially if you have bills to pay.

  Neoclassical Economics
Traditional finance models have a basis in economics, and neoclassical economics is the
dominant paradigm. In this representation, individuals and firms are self-interested agents who
attempt to optimize to the best of their ability in the face of constraints on resources. The value (or
price) or an asset is determined in a market, subject to the influences of supply and demand
Neoclassical economics makes some fundamental assumptions about people:
 People have rational preferences across possible outcomes or states of nature.
 People maximize utility and firms maximize profits
 People make independent decisions based on all relevant information.

Expected Utility Theory

Expected utility is a theory in economics that estimates the utility of an action when the outcome is
uncertain. This theory contends that individuals should act in a particular way when confronted with
decision making under uncertainty. In this sense, the theory is “normative” which means that it
describes how people should rationally behave. This is in contrast to a “positive” theory, which
characterizes how people actually behave.
Expected utility theory is really set up to deal with risk, not uncertainty. Risky situation is one in which
you know what the outcomes could be and can assign a probability to each outcome. Uncertainty is
when you cannot assign probabilities or even come up with a list of possible outcomes.
Risk Attitude

There is abundant evidence that most people avoid risk in most circumstances. People are, however,
willing to assume risk if they are compensated for it. The utility function is useful in determining risk
preferences.
The Pricing of Risk
We mentioned on expected utility theory which says that individuals faced with uncertainty maximize
the utility expected across possible states of the world. Of course, for a financial asset with potentially
innumerable possible outcomes, this is not a manageable task. Fortunately, asset pricing theory
provides a way to quantify the trade-off between risk and return. Before formally considering how
assets should be priced, it is necessary that we examine how the trade-off between risk and return
can be measured.
Market Efficiency
Capital markets are crucial to the development and functioning of an economy because they perform
a critical service. It is through efficient and well-performing capital markets that resources are
allocated to their best use. Market efficiency refers to the degree to which market prices reflect all
available, relevant information. If markets are efficient, then all information is already incorporated into
prices, so there is no way to “beat” the market because there are no undervalued or overvalued
securities available. Because prices always accurately reflect information, they are good signals of
value and encourage the best allocation of capital.
Forms of EMH

Agency Theory
An agency relationship exists whenever someone (the principal) contracts with someone else (the
agent) to take actions on behalf of the principal and represent the principal’s interest. In an agency
relationship, the agent has authority to make decisions for the principal. An agency problem arises
when the agent’s and principal’s incentives are not aligned.
Agency costs that arise from principal-agent problems are both direct and indirect. These costs are
incurred because manager’s inventives are not consistent with maximizing the value of the firm.
Prospect Theory
Normative theory says that reasonable people should act in a certain way. In contrast, positive theory
looks at what people actually do and bases models on these observations. Expected utility theory is a
normative model of economic behaviour that is based on a rigorous axiomatic treatment. Although it
has proven to be very useful in describing how people should behave, some have questioned how
good it is at describing actual behaviour. The most widely accepted and tested alternative to expected
utility theory is the Prospect Theory. Prospect theory is positive because it is firmly based on how
people actually behave.
Challenges to market efficiency
Since the heyday of the market efficiency hypothesis about 30 years ago, researchers have
gradually, both on theoretical and empirical grounds, increasingly chipped away at its edifice. More
recent empirical evidence has uncovered a series of anomalies. Anomalies are empirical results that
appear, until afequately explained, to run counter to market efficiency.
Some key anomalies

Theoretical requirements for market efficiency

Market efficiency theoretically rests on three supports. Only one support is required for market
efficiency. If all three fail, market efficiency can be called into question.
SUPPORT 1: All investors are always rational. The first potential support for market efficiency is
investor rationality, specifically that all investors are always rational. Fischer Black, put it aptly:
People sometimes trade on information in the usual way. They are correct expecting to
make profits from these trades. On the other hand, people sometimes trade
on noise  as if it were information. If they expect to make profits from noise trading, they
are incorrect.

SUPPORT 2: Investor errors are uncorrelated. People may trade on noise because they think
they have useful information or simply because they enjoy trading. The behaviour of such people
may be socially driven or because they observe others trading and don’t want to miss out on a
good thing.
If the behaviour of such traders were random, there would be no cause for concern about the
efficiency of markets because their trades would cancel out. There would be negligible impact on
prices. But, the evidence provided by psychologists indicates that people are subject to the same
kinds of judgment errors---that is, people often deviate from expectations in the same way. This is
where problems arise. If trader’s behaviour is correlated, they may drive prices farther and farther
from fundamental value.
SUPPORT 3: There are no limits to arbitrage. Even if some investors sometimes act irrationally
and their errors are correlated, provided smart-money investors are able to act in such a fashion
so as to arbitrage away incorrect prices, market efficiency will remain intact. This is because any
pricing gap between a relatively expensive security and a relatively cheap one will be vigorously
capitalized on.
 Perception, Memory and Heuristics
Perception
It is common place for an information- processing modes to assume that agents are able to
acquire and store costless information without difficulty. Unfortunately, perception which
downloads information to the “human computer” often misreads it. For example, we
often see what we expect to see. It is also true that people “see” what they desire to see.
Sometimes perception can be distorted in a self-serving fashion. Cognitive dissonance creates a
situation where people are motivated to reduce or avoid psychological inconsistencies, often in
order to promote a positive self-image.
Memory
Imprecision multiplies when one tries to recall past perceptions or views, that is, when one
remembers. The common view that past experiences have somehow been written to the brain’s
hard drive and are then retrieved, even if at considerable effort, is not the way our brain works.
Memory is reconstructive and also variable

Framing Effects
Overconfidence is the tendency for people to overestimate their knowledge, abilities and the precisions of
their information, or to be overly sanguine of the future and their ability to control it. That most people
most of the time are overconfident is well documented by researchers in the psychology literature.

           
It's easy to think of overconfidence as having more confidence in one's abilities than one should
have, but there is an actual definition of overconfidence in psychology. The  American
Psychological Association  defines overconfidence as, "a cognitive bias characterized by an
overestimation of one’s actual ability to perform a task successfully, by a belief that one’s
performance is better than that of others, or by excessive certainty in the accuracy of one’s
beliefs."

Overconfidence bias  can cause people to experience problems because it may keep them from
properly preparing for a situation or may cause them to get into a dangerous situation they are
not equipped to handle.
 

Miscalibration
What is it?
In a research setting, overconfidence can be measured in several ways. We begin with
miscalibration which refers to the tendency for people to overestimate the precision of their
knowledge. It
implies a lack of correspondence between accuracy and confidence. Simply put, it is the

difference between being overconfident and accurate that may lead to grave errors at times in
decisions.

Other strains of overconfidence

Excessive Optimism
Related to illusion of control is excessive optimism. It is present when people assign probabilities
to favorable/ unfavorable outcomes that are just too high/ low given historical experience or
reasoned analysis. In fact, the excessive optimism can be extremely harmful, even toxic. It is not
the same thing having hope that developing an excessive optimism that prevents to accept
reality.
Hope as well as optimism present the image of a positive future. However, while hope imply
having faith that we will get positive results, the excessive optimism implies it for granted. This
kind of optimism develops when we let our emotions manipulate the statistics, to the point that
our desire for something to happen far exceeds the real possibility that such a thing really
happen.
 Excessive optimism, a disease that spreads quickly
We may think that the toxic optimism is a rare disorder, but it is not actually. In fact, it is the
reason why many entrepreneurs fail. These people conceive an idea of business and their
enthusiasm is so great that they think of it as a brilliant idea with all the credentials to succeed.
Led by the excessive optimism, they do not create a plan B for mergency and invest everything
they have on this idea. Thus, when adversity comes, in front of mishaps and problems that
always arise, sooner or later, by the way they don’t have a plan that covers their shoulders, they
end up losing everything.
In fact, the problem is not that the idea is not brilliant, perhaps it is. The real problem is the
excessive optimism, which leads them to take on too much risk, it doesn’t allow them to look at
things objectively and prevents from developing a backup plan that takes into account the
problems that might arise in reality.
Obviously, the excessive optimism is toxic, not only for economic activities, but also for our
personal and professional lives. Compromising too fast in a relationship with a person we just met
can cause us enormous emotional distress, for example.

Better than Average Effect

The better-than-average-effect (BTAE) is the tendency for people to perceive their abilities,
attributes, and personality traits as superior compared with their average peer. One factor that
facilitates a better-than-average belief is that often the exact definition of excellence or
competence is unclear. Naturally enough, people have in the backs of their minds the definition
that will make them look best. On the motivational side, thinking you are better than average
enhances self-esteem. On the cognitive side, the performance criteria that most easily come to
mind are often those that you are best at.
 

10 Traits of an overconfident person (and how to deal with them)

Confidence is definitely a good trait to have. But how do you if someone is crossing the line from
having healthy self- esteem to toxic overconfidence?

So how do you deal with overconfident people?

It is definitely not a walk in the park when you are surrounded by overconfident people.
 Try to understand why they are overconfident in the first place
 Remind them of the truth
 Don’t take it personally
 Keep your cool
 Stand your ground
 Distance yourself

Factors impeding correction

Researchers have tries to explain why overconfidence is so prevalent among people, and, more
puzzlingly, why people fail to learn from past mistakes. It is believed that three behavioral biases
may contribute to the durability of overconfidence. These are self-attribution, hindsight bias and
confirmation bias.

There is still hope

At this point, you’ve probably sensed a pattern of how an overconfident person actually thinks
and feels. All in all, these people lack self-awareness and they usually have a warped view of
reality.

It may be extremely challenging, but we have to believe that there is still hope that overconfident
people can change and improve over time.

In our own little ways, I hope that we can all choose to help these people become more
conscious of their mindset and actions. After all, we are also imperfect and we rely on others to
guide us towards the right path as well.