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How Investors Use the Behavioral Principle in Competitive Financial Markets

written by: John Garger•edited by: Michele McDonough•updated: 4/11/2011

In direct relationship with the signaling principle, the behavioral principle suggests that actions convey valuable information. Knowing when and how to use this principle can mean big returns. Learn how investors use the behavioral principle when making investments.

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    The Behavioral Principle and Investing

    The behavioral principle is directly related to the Signaling Principle but whereas signaling conveys information, the behavioral principle makes use of the information. Information isn’t inherently useful to an investor unless it can be applied to a specific situation in which it is valuable. Knowing what your boss ate for dinner last night is not useful unless you are inviting him over to dinner tonight and you want to make certain you don’t serve something he recently ate. The key is applying the information when the situation calls for it.

    Imitate Successful Behaviors

    Often for investors, there is no clear path to take to ensure profitability. Investors have literally thousands of securities available to them in which to invest funds. A new investor is especially vulnerable to bad decisions simply because of a lack of experience in deciding which securities are most in line with return expectations. One solution is to look at what other investors with more experience are doing. Especially useful is to look at investors with similar situations. For example, young investors have the luxury of time and often invest in riskier securities early in their lives as they can afford to absorb some early mistakes older investors can’t afford to make.

    Ask Advice

    Behavioral Principle Asking a broker’s advice is another application of The Behavioral Principle. A broker, someone who makes a living analyzing and recommending security investments, has all the necessary knowledge and tools available to make informed decisions. His/her advice can be invaluable when the cost of gathering and analyzing the data is too cost prohibitive or just too complicated.

    The Behavioral Principle can be applied in two major situations:

    1. When an investor finds that others are better suited to making decisions.
    2. When an investor find that it is more cost effective to follow the advice or actions of another.

    Blind imitation, however, is dangerous behavior. Such behavior is more common than one would think when large amounts of money are involved. The key is first to decide whether the cost of gathering and analyzing information is worth the effort. If not, then identifying an individual or group to follow is the next best thing.

    The Free-Rider

    One application of the behavioral principle is what’s known as the free-rider problem. A free-rider is any entity that benefits from another’s expenditure of time, money, and effort. Copyright and patent laws seek to protect innovators from having their valuable ideas stolen or diluted from free-riders. But even these laws have limitations and there is no worldwide set of laws governing intellectual property across national boundaries. The lesson to be learned here is to protect your expenditures of time, money, and effort so that free-riders do not reduce the value of your investments, a clear application of the principle of self-interest.

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    Image Credit

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The Competitive Financial Environment

The competitive financial environment is governed by four distinct principles. These principles encompass the idea that attaining value is a matter of competition resulting in winners and losers. The principles outlined here are an overview of this competitive environment.
  1. The Principle of Self-Interested Behavior in Competitive Financial Markets
  2. The Principle of Two-Sided Transactions in Competitive Financial Markets
  3. Signaling in Competitive Financial Environments
  4. How Investors Use the Behavioral Principle in Competitive Financial Markets