There’s no debate that the past year and a half has been a challenging period not just for Americans, but for people around the world. We have seen volatility in the stock market that rattled the confidence of even the most risk tolerant investors. September of 2008 began a two month range of extreme volatility during which the Dow experienced its largest one day point loss, one day point gain and largest intra-day range, closing at a six year low of 7,552 in November of 2008. While we have come a very long way since then, the so called “Flash Crash” on May 6th , where the Dow closed with a 348 point drop after falling as low as 999 points intra-day, reminded us of the looming unpredictability in the markets. While there have been numerous economic and political reasons for such volatility, we can’t ignore the role emotions, such as fear, play in large market swings.
An increasingly popular field in the finance arena is behavioral finance, a combination of psychology and finance to explain why people make seemingly irrational decisions regarding money. Just take a look at the lottery. Millions of people purchase lottery tickets hoping to hit the big jackpot. Logically, it does not make sense to buy a lottery ticket when the odds of winning are overwhelming against the ticket holder (about 1 in 150 million). Most economic and financial theories assume that individuals act rationally and consider all available information when making decisions, but many researchers believe that this is not the case and the incorporation of psychology can help explain many stock market anomalies, bubbles and crashes. Let’s take a look at a few examples that reveal patterns of irrationality in the way people arrive at decisions when faced with uncertainty.
First let’s consider the Prospect Theory which proposes that investors fear losses much more than they value gains. Studies have shown that if an investor is offered the choice of a sure $50 or, after the flip of a coin, the possibility of winning $100 or winning nothing, he or she will most often choose the sure $50. However, if that same person is offered the choice between a sure loss of $50 or, after the flip of a coin, the possibility of losing $100 or nothing, he or she will likely choose the coin toss. Applying this to the stock market, investors willingly remain in a risky stock position hoping that the price will bounce back because they do not want to realize the loss. People are willing to take more risks to avoid losses than to realize gains.
Continuing with the example of a coin toss, another theory, know as the Gambler’s Fallacy, suggests that individuals often erroneously believe that the onset of a certain random event is less likely to happen following an event or series of events. For example, if you flip a coin 20 times and it lands on heads every time, it is common to think that the next one will likely land on tails. This line of thinking is incorrect because past events do not change the probability that certain events will occur in the future. The same goes for choosing numbers on a lottery ticket or pulling the handle of a slot machine.
Human beings tend to fear being left behind in the event of a market upturn. According to the Herd Effect, people tend to mimic the actions (rational or irrational) of a larger group. An infamous example is the bursting of the dot.com bubble in 2000. Herd behavior leads to greed in bubbles and fear in crashes. Fear during crashes such as Black Tuesday of 1929, Black Monday of 1987 and on a smaller scale the 2010 Flash Crash led to massive sell offs.
Although there are many more theories pertaining to behavioral finance, I’d just like to mention two more. The concept of Confirmation Bias proposes that investors tend to look for info that supports their previously established opinion and decision. This leads to overvaluing the stocks of currently popular companies. Along those same lines, the Neglected Firm Effect suggests investors tend to undervalue stock of overlooked companies. This also relates to the Herd Effect: if no one else sees value in this company, why should I?
You’ve all been told the key to making money in the stock market is buying low and selling high, but investors repeatedly do the opposite: they watch a stock go higher and higher until they can’t take it anymore and they buy. As the stock falls, they watch it go lower and lower until they can take no more and sell. I feel strongly that there is enough evidence to prove that investors are not always rational and emotions do come into play in making financial decisions, especially when losses are involved. In 1969, a psychiatrist came up with a 5-Stage process people go through in dealing with grief. Recently this process has been applied to investors coping with the current global financial crisis. The five stages of grief are denial, anger, bargaining, depression and acceptance and I will briefly show how I would assign recent economic events to this process.
During the denial stage, people tell themselves “this isn’t happening to me.” The denial stage of the global financial crisis probably began in late 2007. After the housing market peaked in 2006, home prices had began to decline and people debated whether or not we were in a housing bubble. Subprime lending had skyrocketed over the past 2 years and some people began questioning whether or not there was a mortgage problem brewing. While there were some defaults and foreclosures, many companies still had high earnings expectations and for the most part investors were convinced that any downturn would be temporary.
The denial stage is followed by the anger stage when we ask ourselves “why me?” People often begin to play the blame game. From late 2007 through late 2008, the market faced a deep and steady decline. The blame shifted to many different groups including mortgage brokers (too lenient of lending policies), mortgage holders (took out more than they could afford), regulators (loose regulation), the Fed (lax monetary policy), and Wall Street speculators among others.
The third stage is the bargaining stage during which we have realized that there is a problem and are trying to fix it before things get out of control. I think we entered this stage in late 2008. In September of 2008, the government stepped in to rescue GSE’s Fannie Mae and Freddie Mac to address a capital deficiency and to try to calm the markets. This was followed by a series of bailouts including AIG, the auto industry, Citigroup, and BOA. The Federal Reserve continued lowering the federal funds rate. Unfortunately the economic downturn continued.
The next stage is depression which is characterized by feelings of hopelessness, self pity and mourning. We most likely entered this stage around Spring of 2009 after the Dow closed in March at its lowest level since Spring of 1997. Unemployment had sharply increased and companies engaged in unnecessary mass layoffs as they feared the direction the economy was heading. Those who were laid off feared how they would pay their bills, perhaps most importantly their mortgage, and those who had jobs feared they could lose theirs at any moment.
Acceptance is the final stage of the grief process and is when people begin to deal with reality. I believe that we are currently in this stage and have been since fall of 2009. The market has begun to rebound significantly and unemployment along with other aspects of the economy has stopped getting worse.
In summary, after examining these five stages of grief and how they can be applied to the global financial crisis of 2007-2010, it seems obvious that human emotions do affect the way we perceive the economy and what we do with our money.
So if it is human nature to let emotions play a role in financial decisions, what can you do to lessen the negative effects this can have on your portfolio? Here is one simple answer: have an investment plan and stick to it through thick and thin. In many cases this also means hiring an investment manager. An investment manager can be an unemotional third party that will help prevent you from acting on your impulses. On the contrary, sales people such as brokers benefit financially by catering to investors’ emotions. This is due to the way that they are compensated.
The dust seems to be settling from the major market downturn we have been facing. If you do not have an investment plan or question the one you have, there has never been a better time than now to address those concerns. If you know someone who could benefit from a second opinion, ask them to call us for our free portfolio consultation. More information is available on our website at http://www.alderfinancial.com/PortfolioReview.htm.
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