-Primitive emotions, herd mentality and raging hormones are hidden drivers of stock bubbles and crashes

Posted: September 19, 2008 in 2008, Articles
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Physorg:

Many economists believe that investors make decisions rationally, weighing up corporate data and other pricing signals to evaluate gain or risk before buying or selling stocks.

But this keystone belief in how markets function is now under mounting attack after this month’s global stocks crash, the latest in a string of financial shocks over the past two decades.

Proponents of rival concepts say that primitive emotions, herd mentality and raging hormones are among the invisible motors that help inflate an asset bubble and then prick it.

“In standard economic theory, the way that prices in all markets are meant to be set depends on people being rational and having access to all available information,” says David Tuckett of the Psychoanalysis Unit at University College London.

“This way of looking at things is almost completely wrong,” he said. “Markets are operated by human beings.”

Investigators into the theories of behavioural or emotional finance say conscious decisions are only the surface of a river with deep and powerful undercurrents.

A boom-and-bust event can follow a distinct path, they say.

At first, investors are skeptical about dipping into a market.

When they perceive that neighbours or peers are getting rich by buying a given stock, they cautiously make a purchase and their confidence builds as the stock’s value rises.

The gains fuel enthusiasm, which leads to the euphoric conviction, as the price spirals higher, that this is an easy way to wealth.

At this point — when the bubble is most inflated — the investor becomes indifferent to warning signs, such as share values or price-earnings ratios that are stratospherically high.

What happens when the market starts to tank? The initial response is dismissal, for the investor still believes that his stocks will come back up and there is no point in selling.

As prices slip further, denial cedes to fear and then, suddenly, to panic.

Traumatised by their loss, investors vow never to invest in stocks again — a sentiment that can be durably enforced if many others have also been burned.

A famous example of this process was “Tulip Mania”, which occurred in the 17th-century Netherlands.

Tulip bulbs, then a rarity in Europe, scaled extraordinary heights in the course of a mad year, only to fall just as abruptly.

At the Mania’s peak in 1636, a single bulb of a particularly coveted strain, the Viceroy tulip, changed hands for the equivalent of more than 25,500 euros (36,720 dollars) today. When the bubble burst, there was a wave of moralising and calls for tighter controls against speculators.

Trond Andresen, who specialises in behavioural analysis at the Norwegian University of Science and Technology, says investors may think less about the intrinsic value of a stock and more about the perception of its value.

This is an important distinction, he says.

“Short-term volatility is created when you have people running after each other,” he argues.

“If people stopped chasing what they think the other person is thinking, rather than actually trying to value a stock on their own best terms without second-guessing people, the volatility would disappear.”

John Coates, a Cambridge University researcher into biochemistry and behaviour, says market fluctuations are amplified by hormones.

Read the entire article.

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