The Insecurities and Exchange Commission

When it comes to the Stock Market, analysts have often pointed to particular events as being the “cause” of the Market’s rising and falling.  Even without any evidence as to these influences, analysts continue to explain the Market’s daily “fortunes” by mentioning one event or another which they think explains the day on Wall Street.  And though some have pointed out that the analysts actually don’t agree as to what events have what effect on the Market, there is a strong sense that the Market is often driven not by hard economic news but by intangible and unpredictable psychological factors. 

This week’s plunge on Wall Street is being described as apparently the result of such psychological factors, for example in the New York Times by Vikas Bajaj in his 7 Octoberber 2008 Forget Logic, Fear Appears to Have Edge.   The precipitous fall in the market according to him has become almost a herd behavior.

In his article, Bajaj has an interesting description of what motivates people when it comes to investments.  Here is what he writes:

Fear is an immensely powerful force, perhaps more so than greed, said Andrew W. Lo, a professor at the Massachusetts Institute of Technology who has studied investor behavior.

Scientists who have studied the brain function have found that the amygdala, the part of the brain that controls fear, responds faster than the parts of the brain that handle cognitive functions, he said.

“Fear is a much stronger motivational force,” Mr. Lo added. “The loss of $1,000 has a much bigger impact than the gain of a $1,000.”

He cites a series of groundbreaking experiments in the 1970s by psychologists Daniel Kahneman and Amos Tversky. In one test, they asked students to choose between a sure bet of $3,000, or an 80 percent chance of winning $4,000 (meaning there was a 20 percent chance of winning nothing). Most students said they would take the $3,000.

The same question, framed differently, asked them if they would rather lose $3,000 or accept an 80 percent chance of losing $4,000 (with a 20 percent chance of losing nothing). In this case, they said they would take the riskier bet.

In other words, they were willing to take a bigger risk to avoid losing money than they were when they stood to make more money.

As the study shows when it comes to making big profits people tend to be cautious, but when the risk of losing money is at work, people throw caution to the wind and are willing to take riskier chances and risk bigger losses to try to beat the system.

The activities of investors in the Stock Market seem to closely parallel what actually happened in the banking industry.  Stock Market investors are greatly influenced by rumor and beliefs about things rather than basing their investing decisions on actual fact or hard evidence.  In turns out to be a belief based system – it is not the facts but what people believe about the facts that matters.  This is exactly what caused the banking/lending/home value crisis – much of what was going on in the lending industry ended up being based not upon real cash value but upon what people believed about land values and the economy.  This is as true for individuals as for institutions, except that the instritutions are operating on a grander scale – the hundreds of billions rather than the thousands.  The financial system ends up being based on rumor and beliefs, not upon any audited bottom lines.  It is more like a faith system than a financial system, but populated with people who are as likely to be skeptics as believers.   Maybe it is ironic that the U.S. dollar has printed on it – “In God We Trust” for the amoral financial system is ultimately not based on anything more than the ephemeral get-rich-quick (aka, greed) phantasmagoria of investors and brokers.  Some may think they are dealing in the real world of insured “securities,” when in actuality they are dabbling in the insecurities and superstitions of the human psyche.