The Behavioral Psychology Behind (And Following) Market Crashes

We continue our bedside reading series started last week with with a presentation of Didier Sornette's terrific "Critical Market Crashes" with this week's even more entertaining, introspective and troubling "Psychology, Financial Decision Making, and Financial Crises" by Tommy Gärling and colleagues of the Universrity of Gothenburg. The volatile nature of "product markets" has long troubled thinkers, theoreticians and philosophers alike who have struggled to explain why something which should on its face be efficient, be able to experience such demoralizing and turbulently violent events as May 6, Black Monday, and other historical crashes. Gärling proposes: "In product markets with full competition, prices represent the true value of the products offered. This does however not seem to hold in stock markets where stock prices, due to excessive trading, are more volatile than they should be if reflecting the true value of the stocks. Psychological explanations include cognitive biases such as overconfidence and overoptimism, risk aversion in the face of sure gains and risk taking and loss aversion in the face of possible losses, and influences of nominal representation (the money illusion) of stock prices. If no cognitive biases (strengthened by affective influences) existed or only some actors were susceptible to such biases, individual irrationality in stock markets would possibly be eliminated. This is however not what evidence indicates."

What follows is a fascinating inquiry into the human mind and some of its hardwired traits, and an attempt to explain not only the shock and awe at seemingly irrational market reactions, but people's seemingly pre-programmed biases and responses to various market-induced stimuli, as well as inherent bullish and bearish outlooks that have been known to erupt into outright confrontation and outright drunken bar (and trading desk) brawls on occasion. The paper also goes into an in depth analysis of bubble formation and how this may be borne out of the human mind more so than out of monetary or fiscal largesse.

The paper's most relevant for the current situation observation has to do with the topic of integrity and trust:

A detrimental consequence of financial crises is the loss of trust in financial institutions. Seven determinants of trust (and regaining trust) in financial institutions are discernible: competence, stability, integrity, benevolence, transparency, value congruence, and reputation.

We suggest that all those who wonder why next week ICI will report the 22nd consecutive weekly outflow from funds familiarize themselves with the list above, as currently none of the gating conditions are met.

For all those with time limitations, the paper's summary findings, especially when juxtaposed with the writing of Cognitive Dissonance, can best be captured by the following graphic:

For everybody else, this weekend's recommended reading is below.

"Psychology, Financial Decision Making, and Financial Crises" (pdf)