5 Reasons to Know Why Wealth Maximization is not an Investor’s Ultimate Goal?

It is believed that an investor wants to make money out of investing in financial assets. They tend to realize the goal of wealth maximization from their investments. Their investment decision making is in line with the classic economic theory of utility maximization. But what they fail to realize that they are human being and are bound to make mistakes that might stray them from their investment goals.

Image source: http://www.outofmygod.com

Most models in economics and finance assume that investors are completely rational and that the market is efficient. With these two assumptions, one can develop models that derive equilibrium prices of risky assets, the prices of a unit of risk, the risk premium, the risk-return relationship and so on. Research in applied finance and economics has provided enough evidence that the market is inefficient and that investors are only “semi-rational”, while semi-rationality means that that investors make systematic errors while making their investment decisions. Given the certainty that investors make systematic errors, it seems quite logical that wealth maximization is not the ultimate goal of investment decision making. Following are the five reasons explaining their semi-rational approach to investment decision making, leading to erroneous investment goal:

(i)         Investors ignore in their investment decision-making process the correlation of rates of return on various assets. They don’t see the relationship between two or more different assets return following a similar trend.

(ii)       Decision weights, w(p) – subjective probabilities – are used instead of the true probabilities, p. Investors assign weights to past rates of return even though such rates of return may be irrelevant. Thus, even when the investors are told that the market is efficient and rates of return follow a random pattern, they form their belief based on assets past return.

(iii)           Investors make investment decisions based on the change of wealth, x, rather than the total wealth, w+x, where w is the initial wealth and x is the change in wealth. They perceive each of their investment in the portfolio in relative terms, rather than absolute terms. This approach gives them half the picture of their investments, and they tend to make faulty investment decisions.

(iv)          Individuals in general and investors in particular have “mental department” – also known as mental accounts – (i.e. they make several accounts in their minds, which implies that the aggregate wealth maximization is not the goal of their investment decision making.) Suppose an investor has a portfolio of P₀ value at time t₀, where P₀ consists of a certain portion of equity E₀, and remaining as debt instrument D₀. Essentially, P₀=E₀+D₀. If at time t₁, the portfolio becomes P₁=E₁+D₁, where P₁>P₀, E₁<E₀ and D₁>D₀. He fails to take into account the overall increase in the value of the portfolio; instead he might get panic and make a financial fatal decision.

(v)     In a nutshell, under certain conditions, investors’ deviation from rationality is important in determining asset prices and market dynamics. Literature has already provided sufficient evidence about this phenomenon of irrational or semi-rational behavior of investors and its relationship with asset prices and returns. There is ample support for this theory of investors being non-rational in investment decision making.