The world of finance and economics resolves around ‘rationality’. It assumes that human beings are rational beings. That means they think, decide and act in a balanced and in a coherent manner. These disciplines have built up on the fact that individuals are unbiased in their predictions of future. However, in reality that’s not true. Human beings are individuals chock full of weaknesses, irrationalities and idiosyncrasies. There exist a lot of discrepancies in their thought process, decision making and actions, which makes them an irrational being.
It is a matter of fact that financial markets are extremely volatile in nature. They’ve become even more vulnerable to fluctuations after the Financial Crisis of 2008. While examining the reasons to a financial crisis, economists and other individuals often talk about taxes, liquidity, conflict of interest, loans, governance, frauds and politics but sideline decision making process of an individual to ‘various other reasons’. Although this particular factor seems very fundamental but it contributes equally as other factors do. After all, it is decision making which drives purchases, investment and all the selling!
Emotions like fear, anticipation and greed constantly shape our investment decisions. Overconfidence, inconsistent thoughts or cognitive dissonance, Gamblers’ Fallacy (the belief that if something happens more frequently than normal currently, will happen less frequently in future) and Hindsight bias are few mental biases which affect our decision making processes while making any investment. This is what makes us irrational. There exists a specific discipline which significantly studies these irrationalities, known as Behavioral Finance. Kahneman and Tversky (1979), Shefrin and Statman (1994), Shiller (1995) and Shleifer (2000) are among the leading researchers of this field. In simple terms, this branch of finance intermingles with human psychology. It throws light on why certain people make an investment, buy shares while others sell them.
Studies of major financial crisis reveal that human behavior and fluctuations in a financial market are directly linked. To know why, keep reading!
2008 Financial Crisis
Emerging from the U.S. the 2008 financial crisis shook economies all over the world resulting in a global recession. Reasons to this include, as various researchers suggest, deregulation, securitization and a growth in subprime mortgages. Before this crisis happened, many economic forecasters went unaware about this happening and later events like bankruptcies and defaults. They were unable to figure out what was happening and how deeply is it going to happen. Something was missing; a loophole that solved this mystery. This mystery has forced economists to put forward a question-
“Are human beings really rational?”
Before the crisis had hit the financial world, a lot was going on; from formation of real estate bubble to emerging risks in banking systems. Bubble is a situation when the prices rise strongly and continue to rise further simply because people believe that they will rise in future and therefore encouraging more buying. Hence, overvaluation of price occurs. When this bubble burst, the prices fell rapidly, activating defaults on subprime loans, bringing down the value of banks’ subprime linked holdings and disrupting the banking systems.
Bubbles cannot exist in rational markets because bubbles imply deviations of prices from inherent values. This bubble was also a consequence of irrational thinking. One of such mental biases which contributed in the formation of bubble includes ‘overconfidence’. This is an idea suggesting that people overestimate the precisions of their predictions. For instance, if a person uncovers favorable information about any asset, his or her overconfidence about how reliable the information is leads him or her to push the price of the asset up too high.
Another reason is called the ‘housing effect’. In short, after investors experience gains in their holdings of an asset, they become less risk averse because they are less concerned about future losses because any losses will be cushioned by the prior gains. Their reduced risk aversion leads them to buy the asset even more enthusiastically, thereby pushing its price up even further. Apart from these two, the list of psychological factors contributing in this crisis includes heuristics, loss aversion, extrapolation and more.
Black Monday: October 19, 1987
Black Monday was Oct. 19, 1987, and was marked by a sharp fall in the stock market. In just one week before this day about $1 trillion of US stock market value was wiped out as the Dow Jones Industrial Average had lost a third of its value. Everyone started to sell their shares and the market crashed. Just like the financial crisis of 2008 it occurred without giving any warning and suddenly. There were a number of factors behind it including computer trading strategies, overvaluation of stocks and market psychology.
Market psychology refers to the overall feeling among market participants that push them to buy or sell. When people see the market dropping rapidly they do not want to be in a stock trade, they want to sell quickly and when lots of people do this, a snowball effect is created. Snowball effect refers to a process that starts from an initial state of small significance, builds upon itself and eventually becomes larger. This is what happened on Black Monday. People started selling their stocks and eventually the whole market crashed!
As Vilfredo Pareto puts it,
“The foundation of political economy and, in general, of every social science, is evidently psychology. A day may come when we shall be able to deduce the laws of social science from the principles of psychology.“
The financial world isn’t away from psychology. In fact it is getting closer. So next time you talk about a financial crisis, don’t forget to mention psychological factors! Subscribe to know more.
Author | Ranu Jain