The Nobel prize in Economics last year was awarded to Princeton University’s Daniel Kahneman for the work he and another colleague did in understanding the way people’s thinking can affect financial markets. The citation for the Prize reads for “having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty”.
Kahneman has shown that people’s motives for decision making are a lot less rational and are more heavily influenced by emotional factors than we might previously have thought. And all of this, in turn, has a bearing on the economy.
Kahneman is one of many to study this subject. Overall, studies have shown that individuals:
• Under-estimate uncertainty and think the status quo will be maintained into the future. We tend to think that what we are experiencing now will continue into the future. We don’t consider how different things may be tomorrow.
• Over-estimate the importance of recent spectacular or personal experiences in assessing the likelihood of those events happening again. Events that made a particularly strong impression on us colour our thinking so that we have irrational expectations about the future.
• Focus on experiences that happen to them personally. We are inclined to say, “Well, this is what happened to me, so it must happen to everybody.”
• Tend to be over confident in their own abilities – men more so than women.
• Think events are obvious in hindsight.
• Ignore information that conflicts with past decisions they have made. Habits die hard.
• Seem to want less information when thinking about a desirable event versus an undesirable one. Anticipation can be half the fun.
• Dislike losing money much more than gaining it.
• Are influenced by numerous irrelevant considerations in making decisions.
Take all of these individual behaviours, add a healthy dose of crowd mentality and you invariably get irrational behaviour and irrational markets. A molehill can become a mountain.
Ideal mountain-making conditions occur when there is:
• Some means for contagious spread of the thinking/behaviour such as TV or the internet.
• Some kind of threat like the fear of losing money or power.
• A precipitating event. September 11th was such a catalyst.
Readers may be familiar with the Economic Clock. We have reproduced this here with an inner wheel – the emotional clock.
Economic Clock
Consider how individual decisions, in times of euphoria or despair, are multiplied millions of times to cause much bigger gyrations in whole markets. On the way up, the emotional conditions that cause lapses of logic in individuals very quickly re-enforce an over-optimistic mentality in the crowd. This produces speculative upward surges in asset prices. The same is true in reverse.
None of this is surprising but it is worth remembering that market cycles are not entirely driven by fundamentals. The often irrational and erratic behaviour of an unstable crowd of millions of investors can make their movements much more exaggerated in both directions.
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