Martin LandryDue Diligence Analyst, 1st Global
May 2, 2012
|Recognizing and managing emotions may help keep investing plans intact.|
| By Martin E. Landry, featured in the May issue of Financial Advisor Magazine
Distinguished 20th century American sociologist Robert K. Merton is perhaps best known for having coined the term “self-fulfilling prophecy.” A central element of modern sociological, political and economic theory, it’s a process whereby a belief or an expectation, correct or incorrect, affects the outcome of a situation or the way a person or a group will behave.
Merton took the concept and applied it to the social phenomena of bank runs in the Great Depression. In his book Social Theory and Social Structure, he invents a fictional Last National Bank, overseen by Cartwright Millingville. Mr. Millingville manages the bank in an honest and forthright manner and his, like all banks, has some cash reserves and lends money. One day, a large number of customers come to the bank at once—the exact reason is never made clear. The customers, seeing so many others at the bank, begin to worry. Rumors spread that something is wrong with the bank, and more customers rush there to try to get some money out while they still can. Nervous chatter grows as more people line up, which in turn fuels more rumors of the bank’s insolvency, causing more customers to try to withdraw their money. At the beginning of the day, the bank was not insolvent. But the rumor of insolvency caused a sudden demand of withdrawals that could not be met. So the bank became insolvent after all.
Merton concludes with this analysis: “The parable tells us that public definitions of a situation (prophecies or predictions) become an integral part of the situation and thus affect subsequent developments. This is peculiar to human affairs. It is not found in the world of nature, untouched by human hands. Predictions of the return of Halley’s Comet do not influence its orbit. But the rumored insolvency of Millingville’s bank did affect the actual outcome. The prophecy of collapse led to its own fulfillment.”
Some would say the events of 2011 had characteristics of the self-induced “panic” of a fictional bank run as described by Merton. Last year saw exogenous shocks, geopolitical turmoil, deadly natural disasters, financial market strains, rumors of impending sovereign defaults, political squabbling leading to deadlock—the list could go on and on. It was certainly a time when students of behavioral finance would have a field day!
We saw social uprisings in North Africa and the Middle East toppling strongman regimes. Civil war in Libya led to a spike in crude oil prices and the resulting commodity price increases stoked inflation concerns and blunted consumer behavior. We reacted in sorrow to the tragedy of the Great East Japan earthquake and tsunami, followed by disaster at the Fukushima nuclear plant.
The deepening of the sovereign debt crisis in the euro zone and the contagion effect on the banking sector dominated the daily headlines. Confusion reigned and global stock and bond markets saw volatile bouts of increased selling.
If those events weren’t enough to fret about, we endured a near shutdown of the U.S. government due to political posturing. That paled in comparison to the nerve-racking game of brinkmanship in Congress over the raising of the federal debt ceiling amid discussions about how to address the country’s current annual spending deficits and long-term entitlements. Investors agonized and, in turn, began to yank their money from stock mutual funds. A last-minute deal allowed us to avoid deciding which bills the U.S. Treasury would pay, but it wasn’t enough for the U.S to save its pristine “AAA” credit rating.
With more problems unfolding in Europe, some investors cried uncle and sold, exacerbating the whirlwind of volatility, the talk of dire economic outcomes, the market drops, the sharp snapback rallies and the market’s hypersensitivity to every bit of news.
Behavioral finance attempts to identify and predict the rational and irrational behavior of investors, who, driven by the emotions of greed and fear, join in the frantic purchasing and sale of financial assets, creating bubbles and crashes.
One area of interest in behavioral finance is “heuristics,” rules of thumb in which current behavior is judged to be correct based on how similar it is to past behavior and its outcomes. The idea is that reasons for past behavior still hold true for new situations, so they can be correctly applied again. Heuristics are used to speed up the process of finding a solution when an exhaustive search is impractical. They help us identify “cognitive biases,” a general term used to describe distortions in the human mind that are difficult to eliminate and lead to inaccurate judgment or illogical interpretation. Investigations into such biases in investing are based on pioneering research by psychologists Daniel Kahneman and Amos Tversky.
There is no doubt that the financial crisis of 2008 and the subsequent deep recession left psychological and emotional scars on investors. 2011 brought many of the fears and anxieties back. Even though we are more than three years removed from the depth of the crisis, lately it doesn’t seem to take much for investors to panic and head for the exits. We have been witness to, and sometimes participants in, “information cascades.” This cognitive bias is the tendency to ignore our own objective information or private insights and instead focus on emulating the actions of others. Michael Mauboussin of Legg Mason Capital Management points out in his book More Than You Know that the stock market has no defined outcome and no defined time horizon, so it’s the prices in the financial market that both inform its participants about the future and influence decisions. Efficiency is lost when investors imitate one another or when they rely on the same “information cascades.” These induce market players to take the same course of action (buy or sell) based on the same signals from the environment, without consideration that others are doing likewise (or that it may be in the best interest of the player to refrain from taking the same action).
In some sense, information cascades are related to herd behavior, exacerbated during periods of extreme negative sentiment. “That unintended system-level consequences arise from even the best-intentioned individual-level actions has long been recognized,” Mauboussin writes in his second book, Think Twice. “But the decision-making challenge remains for a couple of reasons. First, our modern world has more interconnected systems than before. So we encounter these systems with greater frequency and, most likely, with greater consequence. Second, we still attempt to cure problems in complex systems with a naïve understanding of cause and effect.”
Recently, Mohamed El-Erian, the co-chief investment officer at PIMCO, opined in The Huffington Post, “In such environments, market liquidity becomes more elusive, counterparty risk concerns mount and certain investors turn into distressed sellers. As illustrated in the 2008 global financial market meltdown, these issues can become disruptive in themselves, fueling a chaotic economic and technical deleveraging process.” If these feedback loops don’t flame out on their own, they can do real harm to the “real” economy by persuading people to postpone or cancel spending that was rational before the feedback started.
Feedback loops involving investor confidence occur in the context of a complex social and psychological environment. Robert Shiller stated in his famous book Irrational Exuberance that feedback loops are a vicious circle.
“Underlying this feedback is a widespread public misperception about the importance of speculative thinking in our economy. People are accustomed to thinking that there is a basic state of health of the economy, and that when the stock market goes up, or when GDP goes up, or when corporate profits go up, it means that the economy is healthier,” Shiller wrote. “It seems as if people often think that the economy is struck by some exogenous maladies, and that the stock market is just a reflection of those shocks. But people do not seem to perceive how often it is their own psychology, as part of a complex pattern of feedback, that is driving the economy.”
While asset price bubbles represent one set of challenges, it is during times of negative feedback cycles that restraint and thoughtfulness must prevail. Merton concluded that the only way to break the cycle is to redefine the propositions on which the false assumptions were originally based.
The world is an unsettled place; the future course of events is not predictable with enough precision to prevent further information cascades, negative feedback loops or self-fulfilling prophecies. Things can change quickly. Rumors seem to morph into reality, while sanity and common sense take a back seat to catastrophizing. During these times, the best thing you can do is recognize and manage your emotions and impulses and keep your investing plan intact. If you are a financial advisor, these are the times where you earn your pay. Your clients will need emotion and impulse management as well. It may be during those occasions that we step back, take a deep breath and think through our actions and the consequences.
Whether the remainder of 2012 will bring about the kinds of unexpected surprises we experienced in 2011 is unknown. Having a better awareness of our human biases can certainly help us navigate uncharted waters.
Martin E. Landry, CFA, CFP, CAIA, CIMA, CIPM, is an investment due diligence analyst for 1st Global Capital Corp.