When Fear Drives Our Decisions, Forget Logic

8 10 2008

So sayeth the New York Times:

. . .the market has become a case study in the psychology of crowds, many experts say. In normal times, it runs on a healthy mix of fear and greed. But fear now seems to rule, with investors often exhibiting a Wall Street version of the fight-or-flight mechanism — they are selling first, and asking questions later.

“What’s happening is people are crawling into a bunker and pulling an iron sheet over their heads because they think the sky is falling,” said William Ackman, a prominent hedge fund manager in New York.

And that bunker is getting very crowded, so much so that some analysts are starting to suggest the markets are showing signs of “capitulation” — another term of art to describe what happens when even the bullish holdouts, the unflagging optimists, throw up their hands and join the stampede out of the market.

. . .To some, signs of capitulation can be read as an indicator that the bottom may be near. Indeed, Sam Stovall, chief investment strategist at Standard & Poor’s Equity Research, is among those who say the market may be close to a bottom.

. . .The opposite of capitulation, of course, is investing at the height of a bubble. One oft-cited sign of the housing market’s top: when dinner parties are dominated by stories about fast profits on flipped condominiums. During the dot-com boom in the late 1990s, it seemed everybody and their grandmothers were piling into stocks. Now they are bailing out.

. . .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.

Those instincts seem to be taking over.

At this point, any spreadsheet analysis of underlying and intrinsic values of stocks becomes meaningless, and concern for preserving wealth overrides the desire to grow it — what some may call greed.

“With negative emotions we tend to have a desire to change the situation,” said Ellen Peters, a senior scientist at Decision Research in Eugene, Ore. But “when things are good there is not much desire to change.”

. . .If the market is indeed close to the bottom, history suggests any rally in the next few weeks will probably be big. Since World War II, Mr. Stovall estimates stocks have recouped about a third of their bear market losses in the first 40 days after the market hits bottom.

I’ve started to read the new behavioral economics book, “Predictably Irrational: The Hidden Forces That Shape Our Decisions” by Dan Ariely. Never mind how to change the world or anyone else’s mind, just working to keep control of my OWN world and my OWN mind is hard enough!

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2 responses

8 10 2008
Deanne

“…a healthy mix of fear and greed. ”

This really jumped out at me. I mean how could such a mix ever be HEALTHY!!! ;P

8 10 2008
Nance Confer

Just as healthy as McCain apparently thought our economy was before the polls and his campaign advised him otherwise.

Nance

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