How individual investors make investment decisions in practice rather than in theory; and
How investors manage their funds/savings/ investments in light of current stock markets.

According to portfolio theory an optimal portfolio and efficient frontier is described as a portfolio which provides an investor maximum return for a given level of risk or lowest risk for a desired level of return and an efficient frontier is a set of such portfolios. Several tools and techniques are available with professionals to identify such portfolios such as capital asset pricing model, beta, risk free and market rate of return, etc. But in reality, an average investor who invests himself and does not take any professional consultation choses his investment picks and makes his decisions in a rather different manner. His decisions are more governed by different set of factors, other than the theoretical principles.

In my opinion, stocks never trade on actual value. In fact, it trades on perceived value. The movements or sudden changes observed in stock prices are direct consequences of changes in perceptions of investors about a possible future event. This perception may be associated with a particular company, industry or the general business environment as a whole. History has proved that events like September 11 had drastic effects on the stock markets. These events cannot be compared to portfolio theories as these are outcomes of sudden changes in environment and no theory can describe these.

An average or retail investor is the one which constitutes the largest base of investors in the market. Most of these investors are either active or passive investor with little or no knowledge about portfolio theories and knowledge of technical indicators and other economic concepts. Their decisions are purely based on their perception of the individual security and the market as a whole. They take the position in a security on the basis of certain factors such as some expected news about the product, mergers and acquisitions, forecast of the industry which is published in some newspaper of magazine, investment decision made by another friend or relative etc. Therefore, he enters into a stock with satisfied and positive perception, governed by a set of factors and information which is publicly available. He does not care to inquire how good the company looks on the charts, what positive or negative effect on the earnings of the company might have, in the scenario if that event happens or does not happen, etc. His investment in the stock is induced more by the excitement to generate some extra money. This is the reason we see considerable volumes in certain equities during earnings time, news of potential mergers, etc. A classic example of this kind of sudden interest is pharma companies which are planning to go for FDA approval of their drugs. As soon as the news comes to the market that the drug of the company might get approved by FDA, people start accumulating the stock without even worrying of the consequences on the stock if the drugs get disapproved.

However, not all retail investors behave in the same way. There is still a class of active investors who have better idea of the market, has the capacity to hold the stocks from a longer term perspective and has strong conviction about the growth of the stock due to extensive knowledge obtained from personal research as well as special knowledge due to association with that particular company or industry.

But overall, the retail investors are ones who are hit the most when markets take a dip. Most of the retail investors, including a large percentage of sophisticated investors, have little or no knowledge of hedging mechanisms and derivatives such as puts and options. Even though these people have started using it now after bearing huge losses in market crash such as that of dot com burst, the percentage is still very minuscule. The majority of retail investors do not enter the market with a perfect objective of long term and safe financial planning with choice of investments perfectly suiting their risk taking capacity. Instead, their idea is to make some quick bucks and return on investment as compared to their other investments such as savings account or fixed deposits.

I would like to say that not everyone in this world can become Warren Buffett because not everyone has the ability to identify the best picks and take high risks. Therefore, a retail investor's foray into market is more governed by the appeal and excitement in the market rather than on something concrete.

IF we talk about the current market scenario of US equity markets, we have seen that US markets (both Nasdaq and NYSE) have remained flat due to uncertainties governing the market such as policies of the Fed with respect to interest rate hikes, oil prices, terrorism and global weakness of dollar as well as sluggish economy. It was only during the end of 2005 that markets recovered a little bit and showed very little gains. Overall, everything has been range bound and thereby, creating difficulties for the retail investor. Sophisticated retail investors who have knowledge about derivatives invest and trade in derivatives such as calls and puts to take advantage of movement of both sides. Retail investors are generally frustrated in this kind of market due to flat returns. Some of them who turn passive investors by becoming stock specific make better money than other who try to invest in everything and end up losing on most of them due to flat market.

Different types of risks which the investors face are with respect to sudden change in market or business conditions leading to bearish trend in the market, company specific risks with respect to weak earnings, unfavorable news, etc. Retail investors, with their limited knowledge of the market, can do little to prevent or mitigate such risks and rely on their intuition to take decisions in such situations and often act in a hasty manner leading to panic and ultimately, wrong decisions. There are a small number of sophisticated investors who know about hedging strategies via options (Calls and puts) and diversification of portfolio and stop losses. But in practicality, this percentage is very small.