Investor Psychology: Fear Turns People Into Sheep → Washingtons Blog
Investor Psychology: Fear Turns People Into Sheep - Washingtons Blog

Friday, November 6, 2009

Investor Psychology: Fear Turns People Into Sheep

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.
An article yesterday in Alternet discussing the Sociological Inquiry article helps us to understand that the key to people's active participation in searching for excuses for actions by the big boys is fear:

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?

Congressmen Brad Sherman and Paul Kanjorski and Senator James Inhofe all say that the government warned of martial law if Tarp wasn't passed. And Rahm Emanuel famously said:

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.

Last year:

  • 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.


  1. To borrow an old submarine term this kind of market manipulation can only lead to exceeding crush depth (complete failure) caused by implosion. All this trading based of some magic quant theory that nobody understands can only lead to collaspe.

    While us common folks eyes roll back in our heads and look up reruns of Archie Bunker.

  2. Investment decision? You gotta be kidding me. There is absolutely no way a common man and probably most professional investors can make a rational decision is this market. With all the bells and whistle trading going on out there , Hedge funds moving stock prices anyway they want , whenever they want , makes any kind of analysis by almost anyone a joke. I always have believed that fundamental analysis was a huge joke, to suppose you could tell the fortunes of a company 1, 5, 10 years out in my book was always a myth . A myth that has been demonstrated over and over again. Particularly today , when this company you have invested large amounts of time studying becomes the target of a hedge fund. The word investment needs to be changed to a CRAP SHOOT.

  3. The secret to trading successfully is to get in sync with the market.

    In our fast paced computer age of easily placed online stop and limit orders across a multitude of markets has meant that traders like never before have removed themselves from the price action where the focus is invariably on the latest indicator, tool or theory to analyse what will happen next rather than spending time actually watching and imprinting the price action in real time onto ones brain.

    Not so long ago market charts had to be drawn by hand, this meant that one was forced to stay focused on the price action as it unraveled before one which generates greater FOCUS for one is more in tune or in synch with the market i.e aware of the changing character of the market which can warn of a significant imminent market moves, instead traders today are immersed in countless indicators that distract them from the market price into a state of confusion as if the phrases of convergence and divergence to the price carry's any real meaning, which is ever only clear in hindsight.

    I suggest that if you really want to learn to trade then forget about using the computer generated charts, you need to draw these by hand, add trendlines and support resistance levels and nothing more, do this in real time so the most appropriate time frame would be the hourly chart. Yes this means you only trade one market at a time, but that is how it should be!

    As you actually watch and interpret price action for your single market in real time, you will gain new insights into its character and changing behaviour and get in synch with the market, something you will not gain from any indicator, all of which distance one from the unfolding price action by introducing far too much complexity in its interpretation. Example of being in synch with the market -

  4. Who's the bonehead that responded "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." after being told the truth? Are there really Americans that are that idiotic?

    We really need to increased the accessibility of an education to those people.

  5. It was a time of golden visions in a blaze of glory that led on to riotous feasting on the rim of the crater of ruin-a brief era of wild extravagance in theories and in practices . There were many contributing factors to explain the boom ; and,given the boom ,the collapse was inevitable.
    The contagion which spreads from one member of the group to another until the whole is caught up in a frenzy of buying or selling.
    Above by , Walter Prescott Webb . about 1932 .
    So, there is nothing new under the sun , it happens over and over again.


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