How understanding economics principles help to make better investment decision?

March 16, 2020 | Gaurab Subedi

There are various principles of economics which is useful for making investment decisions . One of the principles of economics is people face trade off. Making decisions requires trading off one goal against other.A classic example to clarify trade off while making investment decision is understanding risk return trade off. High risk is associated with higher profits and lower risk is associated with lower profit. Picking up penny stocks having high risk- high return or buying high performing stock having low risk-low return is for you to decide.

Second is an opportunity cost. Opportunity cost refers to whatever must be given up to obtain some item. So while making investment decisions, you must be aware of the opportunity costs that accompany each possible action. The opportunity cost of any action is simply the next best alternative to that action – or put more simply, “What you would have done if you didn’t make the choice that you did”. For instance, depositing money in a fixed deposit account in a bank yields 10% annual interest in your amount. You will not get that interest which is an opportunity cost if you decide to invest that amount in buying shares.

Next is a rational person think at margin. Margin means edge and so marginal changes are adjustments around the edges of what you are doing. Rational people often make decisions by comparing marginal benefits and marginal costs. A rational decision maker takes an action if and only if the marginal benefit of the action exceeds the marginal cost. This is very applicable in stock trading as many of us look for day trading and also short term investment to make instant profit.

Economics is everywhere, and understanding economics can help you make better decisions and lead a happier life– Tyler Cowen

Also people are willing to pay high for stocks which are less in volume than the stocks that are abundant in the market. People believe the marginal benefit of less traded stocks with less volume to be more than stocks that are traded in high number. Example are high P/E ratio of micro finances in Nepal and dipping value of commercial banks due to high volume of shares listed in NEPSE.

Another principle is people respond to incentives. Incentive refers to rewards and punishment and how a person acts to these prospects. Incentives are very crucial to analyzing how markets work. For instance, when the price of the stock increases people think they can profit from investment so they are ready to participate more in stock trading. While market is going up, everyone starts making money and they are attracted to the market. But when the stock price is falling, the fear of losing restricts from more trading activities. For instance, the high number of share volumes are traded during bull and opposite case is observed during bear market.

What is interesting about above principle is that it somehow helps to understand the psychology of an individual while making investment decisions. They  are definitely influenced by the trade offs they face, the opportunity they let go, their requirement of some return to their action, the eventual result of their action and their response towards it.

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