Friday, November 6, 2009
Investors are basically rational, right?
In fact, as many studies have demonstrated, the answer is no.
But instead of wading through all of the investment psychology research, let's look at research into people's basic reasoning abilities. Bear with me for a minute. A study in an area unrelated to investing sheds light on people's basic thinking processes.
Sociologists from four major research institutions investigated why so many Americans believed that Saddam Hussein was behind 9/11, years after it became obvious that Iraq had nothing to do with 9/11.
The researchers found, as described in an article in the journal Sociological Inquiry (and re-printed by Newsweek):
- Many Americans felt an urgent need to seek justification for a war already in progress
- Rather than search rationally for information that either confirms or disconfirms a particular belief, people actually seek out information that confirms what they already believe.
- "For the most part people completely ignore contrary information."
- "The study demonstrates voters' ability to develop elaborate rationalizations based on faulty information"
- People get deeply attached to their beliefs, and form emotional attachments that get wrapped up in their personal identity and sense of morality, irrespective of the facts of the matter.
- "We refer to this as 'inferred justification, because for these voters, the sheer fact that we were engaged in war led to a post-hoc search for a justification for that war.
- "People were basically making up justifications for the fact that we were at war"
- "They wanted to believe in the link [between 9/11 and Iraq] because it helped them make sense of a current reality. So voters' ability to develop elaborate rationalizations based on faulty information, whether we think that is good or bad for democratic practice, does at least demonstrate an impressive form of creativity.
Subjects were presented during one-on-one interviews with a newspaper clip of this Bush quote: "This administration never said that the 9/11 attacks were orchestrated between Saddam and al-Qaeda."
The Sept. 11 Commission, too, found no such link, the subjects were told.
"Well, I bet they say that the commission didn't have any proof of it," one subject responded, "but I guess we still can have our opinions and feel that way even though they say that."
Reasoned another: "Saddam, I can't judge if he did what he's being accused of, but if Bush thinks he did it, then he did it."
Others declined to engage the information at all. Most curious to the researchers were the respondents who reasoned that Saddam must have been connected to Sept. 11, because why else would the Bush Administration have gone to war in Iraq?
The desire to believe this was more powerful, according to the researchers, than any active campaign to plant the idea.
Such a campaign did exist in the run-up to the war...
He won't credit [politicians spouting misinformation] alone for the phenomenon, though.
"That kind of puts the idea out there, but what people then do with the idea ... " he said. "Our argument is that people aren't just empty vessels. You don't just sort of open up their brains and dump false information in and they regurgitate it. They're actually active processing cognitive agents"...
The alternate explanation raises queasy questions for the rest of society.
"I think we'd all like to believe that when people come across disconfirming evidence, what they tend to do is to update their opinions," said Andrew Perrin, an associate professor at UNC and another author of the study...
"The implications for how democracy works are quite profound, there's no question in my mind about that," Perrin said. "What it means is that we have to think about the emotional states in which citizens find themselves that then lead them to reason and deliberate in particular ways."
Evidence suggests people are more likely to pay attention to facts within certain emotional states and social situations. Some may never change their minds. For others, policy-makers could better identify those states, for example minimizing the fear that often clouds a person's ability to assess facts ...
The Alternet article links to a must-read interview with psychology professor Sheldon Solomon, who explains:
A large body of evidence shows that momentarily [raising fear of death], typically by asking people to think about themselves dying, intensifies people's strivings to protect and bolster aspects of their worldviews, and to bolster their self-esteem. The most common finding is that [fear of death] increases positive reactions to those who share cherished aspects of one's cultural worldview, and negative reactions toward those who violate cherished cultural values or are merely different.
Fear in the Economic and Financial Arenas
Has something similar happened in the economic/financial arenas?
Never let a serious crisis go to waste. What I mean by that is it's an opportunity to do things you couldn't do before.
- Senator Leahy said "If we learned anything from 9/11, the biggest mistake is to pass anything they ask for just because it's an emergency"
- The New York Times wrote:
"The rescue is being sold as a must-have emergency measure by an administration with a controversial record when it comes to asking Congress for special authority in time of duress."
Mr. Paulson has argued that the powers he seeks are necessary to chase away the wolf howling at the door: a potentially swift shredding of the American financial system. That would be catastrophic for everyone, he argues, not only banks, but also ordinary Americans who depend on their finances to buy homes and cars, and to pay for college.
Some are suspicious of Mr. Paulson’s characterizations, finding in his warnings and demands for extraordinary powers a parallel with the way the Bush administration gained authority for the war in Iraq. Then, the White House suggested that mushroom clouds could accompany Congress’s failure to act. This time, it is financial Armageddon supposedly on the doorstep.
“This is scare tactics to try to do something that’s in the private but not the public interest,” said Allan Meltzer, a former economic adviser to President Reagan, and an expert on monetary policy at the Carnegie Mellon Tepper School of Business. “It’s terrible.”
Not Just Government
But it's not just government . . .
If the too big to fails say that the world economy will crash and there will be martial law unless they are bailed out, politicians - most of whom don't understand finance or economics - will believe them, and sound the alarm themselves.
As Karl Denninger wrote yesterday:
[AIG's CEO] left Geithner with two documents. One was a fact sheet that listed all the attributes of AIG FP [the division run by Joe Cassano that blew the company up] and argued why it should be given status as a primary dealer. The other–a bombshell that Willumstad was confident would draw Geithner’s attention–was a report on AIG’s counterparty exposure around the world, which included “2.7 trillion of notional derivative exposures, with 12,000 individual contracts.” About halfway down the page, in bold, was the detail that Willumstad hoped would strike Geithner as startling: “$1 trillion of exposures concentrated with 12 major financial institutions.”
Was that a threat?
And isn't threatening the United States (whether directly or otherwise) something you're not supposed to do?
Sounds like "Bail me out or I will crash everything."
Isn't that analagous to walking into a bank, opening one's coat to reveal an explosives-laced belt, and saying "gimme all the money or everyone dies!"
Yves Smith has previously used a similar analogy.
Fear Among Individual Investors
Investors - as with politicians or Americans in general - believe that "when [they] come across disconfirming evidence . . . . they tend to ... update their opinions", but in reality, they cling to the beliefs they formed during certain heightened emotional states, such as fear.
Fear turns people into sheep. Once they are sheep, they will strive mightily to justify the actions of their "leaders" - whether those leaders gave trillions of dollars in bailouts or got us into war, and even if the leaders' justifications were false.
I believe this dynamic is also playing out in the fact that many Americans assume that the government has a real plan for fixing the economy, is working as hard as it can to do so, and that - eventually - things will improve.
Just as most Americans believe "since we're at war in Iraq, and since the government previously claimed that Saddam was behind 9/11, he must have been", they are probably thinking "since the government gave trillions to the giant banks and said that economists have figure out how to fix things, they must have done what was needed, and things will turn around in a v-shape recovery".The lengths people go to rationalize a false link between Saddam and 9/11 is a great example, because it may reveal by analogy how far people will go to justify their trust in our economic leaders and in their own investment decisions.
Of course, the yearning for high returns is the other half of what drives investor psychology. But this essay focuses on fear.