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Stock Market Investors Don't Go with the Flow

/ Learning to Invest May 24, 2010 - 08:51 AM GMT

By: Douglas_French

Diamond Rated - Best Financial Markets Analysis ArticleAnyone who follows financial markets has to wonder at times, "What are people thinking? How did they come to make those decisions?"

It's hard to imagine that John Muth and Robert Lucas came up with what's known as the "rational-expectations theory," wherein, as explained in Wikipedia,

it is assumed that outcomes that are being forecast do not differ systematically from the market equilibrium results. That is, it assumes that people do not make systematic errors when predicting the future, and deviations from perfect foresight are only random.

Muth and Lucas should watch daily programs on the financial channels like Jim Cramer's Mad Money, which is supposedly to help individual investors, or CNBC's Fast Money, a show clearly geared toward speculators. No viewer can watch these shows and walk away believing, "people do not make systematic errors when predicting the future."

So while financial markets have been a series of speculative bubbles as the Federal Reserve creates money ad infinitum, rational-expectations economists Robert Flood and Robert Hodrick daringly conclude, "The current empirical tests for bubbles do not successfully establish the case that bubbles exist in asset prices."

The efficient-markets hypothesis (EMH) is the rational-expectations school of the investing world. The efficient-market hypothesis asserts that financial markets are "informationally efficient," claiming one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis.

Bob Murphy wrote recently on about Chicago School economist Eugene Fama, who is the father of the efficient-markets hypothesis.

Fama is not a Nobel laureate, but he did coauthor The Theory of Finance textbook with Nobel winner Merton H. Miller and he himself won the 2005 Deutsche Bank Prize in Financial Economics as well as the 2008 Morgan Stanley–American Finance Association Award.

Fama was interviewed by the New Yorker's John Cassidy, which was the basis for Murphy's article.

Cassidy asked Fama how he thought the efficient-market hypothesis had held up during the recent multiple financial crisis. Fama said,

I think it did quite well in this episode. Prices started to decline in advance of when people recognized that it was a recession and then continued to decline. There was nothing unusual about that. That was exactly what you would expect if markets were efficient.

When Cassidy mentioned the credit bubble that lead to the housing bubble and ultimate bust, the famed professor said,

I don't even know what that means. People who get credit have to get it from somewhere. Does a credit bubble mean that people save too much during that period? I don't know what a credit bubble means. I don't even know what a bubble means. These words have become popular. I don't think they have any meaning.

"I think most bubbles are twenty-twenty hindsight," Fama told Cassidy. When asked to clarify whether he thought bubbles can exist, Fama answered "They [bubbles] have to be predictable phenomena."

I don't know what Professor Fama's been smoking or whether he's just in denial or not paying attention, but, especially since Richard Nixon cut the dollar loose from gold, it's been one bubble and bust after another.

"It's hard to be a contrarian. With the bubble in full bloom, the last thing you want to tell the boys at the club is that you have your money in cash or gold."

And clearly in a boom people go crazy. Another term for bubble is mania, and according the Webster's, "mania" is defined in an individual as an "excitement of psychotic proportions manifested by mental and physical hyperactivity, disorganization of behavior, and elevation of mood."

Robert Prechter, in his book View From The Top of the Grand Supercycle, points out that mania refers specifically to "the manic phase of manic-depressive psychosis."

Economists Kevin McCabe and Colin Camerer combined with neuroscientist Read Montague to do a study of financial markets where the subjects of the experiment were given $100 to invest, making their decisions against 20 different markets. Montague and the two economists used historical market prices, measuring the brain and behavioral responses to these.

The researchers were especially interested in how their subjects would respond to markets featuring bubbles and crashes. The subjects' brains were scanned while they created and reacted to market bubbles with their investments. Fifty-two subjects played the investment game in the scanners but had no idea they were playing in actual historical markets.

Two of the markets used in the simulation were particularly brutal to the fifty-two participants; the 1987 stock-market crash and the 1929 crash. None of the subjects earned money in the 1929-crash simulation and many lost more than half their portfolio.

"This market," Montague explains, "out of all twenty used, lulled subjects' decision mechanisms into a kind of stupor and then — bang. Goodbye, money."

The variable that most drove behavior in the investment game in all markets was — regret. Regret was a big factor when subjects changed their investments and also "showed up as an extremely strong neural signal in a reward-decision-making region of the brain, the ventral putamen, the same site where reward-prediction error signals appear."

Montague believes this is significant because, as gambling games evolved to "exploit the frailties of our biological valuation and decision-making machinery," the 1929 market "hit a kind of fragile 'sweet spot' of valuation and decision machinery in the subject's brain."

Regret, in this case, is the difference between the value of what is and the value of what could have been. This is important because of dopamine, which is a chemical in the brain that helps humans decide how to take actions that will result in rewards at the right time.

People don't get a dopamine kick when they get what they expect, only when they make an unexpected windfall. So, as Jason Zweig writes in Your Money and Your Brain, drug addicts crave ever-larger fixes to achieve the same satisfaction and "why investors have such a hankering for fast-rising stocks with 'positive momentum' or 'accelerating earnings growth'." Also, dopamine dries up if the reward you expected fails to materialize.

The brain has 100 billion neurons and only one-thousandth of one percent produce dopamine, but "this minuscule neural minority wields enormous power over your investing decisions," cautions Zweig.

"Level-headed investors can (and have) been caught up in investment booms and manias."

Dopamine takes as little as a twentieth of second to reach your decision centers, estimating the value of an expected reward and more importantly propelling you to action to capture that reward. "We've evolved to be that way," explains psychologist Kent Berridge, "because passively knowing about the future is not good enough."

The effect of all this is what Zweig refers to as "the prediction addiction." Humans hate randomness. We want to predict the unpredictable, which originates in the dopamine centers of the reflective brain, according to Zweig, leading humans to see patterns where none really exist.

The whole technical-analysis field that Wall Street embraces, is based upon the human desire to predict, and when seeing two occurrences in repetition, people believe (or want to believe) that a trend is in process that, most importantly, they can profit from.

When Parkinson's patients are given drugs to allow their brains to be more receptive to dopamine, they have the insatiable urge to gamble. When these drugs are stopped, the gambling stops immediately. But unfortunately, when we get what we expect, no dopamine rush ensues.

These neurologists don't talk about the Austrian business-cycle theory. For that we turn to Ludwig von Mises, who explains that when the central bank lowers interest rates below the natural rate of interest, engineered by an expansion in liquidity,

the drop in interest rates falsifies the businessman's calculation. … The result of such calculations is therefore misleading. They make some projects appear profitable and realizable which a correct calculation, based on an interest rate not manipulated by credit expansion, would have shown as unrealizable. Entrepreneurs embark upon the execution of such projects. Business activities are stimulated. A boom begins.

Computational neuroscientists would add that not only do the projects appear profitable on paper but also that dopamine is released into the brains of entrepreneurs as they anticipate future profits.

After all, it's ingrained into the business and investing public's collective brain that the lowering of short-term real interest rates, and eventually long-term rates, will have a broad and deep impact throughout the economy.

For example, mainstream economist Dr. Yoshi Fukasawa from Midwestern State University writes,

Lower real interest rates stimulate business investment by making more investment projects profitable.

Reduced interest costs mean that more machines and equipment will be bought, new factories and warehouses built, and additional stores and apartment buildings opened.

Businesses may also increase production because of a lower cost of financing inventories. A fall in interest rates thus peps up investment and production.

Lower interest rates also induce investors to move out of interest bearing investments like CDs and bonds and into stocks, causing a stock market rally. For this reason, investors in the stock market generally embrace the news of a lower interest rate. Higher stock values, in turn, make it easier for businesses to issue more stocks to finance additional investment.

As Ludwig von Mises wrote in The Causes of the Economic Crisis,

The moderated interest rate is intended to stimulate production and not to cause a stock market boom. However, stock prices increase first of all. At the outset, commodity prices are not caught up in the boom. There are stock exchange booms and stock exchange profits. Yet, the "producer" is dissatisfied. He envies the "speculator" his "easy profit." Those in power are not willing to accept this situation. They believe that production is being deprived of money which is flowing into the stock market. Besides, it is precisely in the stock market boom that the serious threat of a crisis lies hidden.

So the excess liquidity created by the central bank is invested in stocks. As the prices of these stocks rise, investors' dopamine levels increase from the expectation of gain, riskier stocks are then bid up in price by investors because more risk must be undertaken to achieve the same dopamine rush and a market becomes a bubble.

The modern world of financial markets is one long series of unending booms and busts. But the investing public falls for it every time. Rates are going down; the economy will get better; stocks are going up; real estate is going up — I better pile in! I don't want to miss the boat. I don't want to regret not getting in on the action.

"The simple fact is most people just do not have brains suitable for investing."

What can explain this groupthink?

Solomon Asch's work on conformity demonstrate that groupthink is extremely powerful. His experiments show that people influenced by a crowd will knowingly make wrong decisions 70 percent of the time.

Emory University neuroscientist Gregory Burns found that when people broke ranks with the conforming group, areas of the brain lit up that are associated with negative emotions. "In other words, nonconformity is an emotionally traumatic experience," writes Michael Shermer in The Mind of the Market, "which is why most of us don't like to break ranks with our social group norms."

The fact is, it's hard to be a contrarian. With the bubble in full bloom, the last thing you want to tell the boys at the club is that you have your money in cash or gold. They'll make fun of you: "What are you, a wimp? Come on, this is easy. We're cleaning up. You're going to regret it if you don't." Then your spouse starts in on you. "How are our stocks doing honey? When are we going to pick up some rental properties like the Joneses next door?"

Groupthink studies show that good people can do evil things. That "evil is facilitated through the contagious excitement of the group's actions, through the unchecked momentum of the smaller bad steps that came before, and ultimately permission for evil is granted by the system at large," writes Michael Shermer.

By the same token, level-headed investors can (and have) been caught up in investment booms and manias. Even the best of investors can lose their heads. So if the stock market is going up, people pile in. There's even a name for it: "momentum investing."

Of course, ultimately the fundamentals of the investments do not support the prices. Market prices cool and dopamine levels dry up, as expected gains don't materialize. A crash ensues with investor regret.

The booms end in tears. The ultimate bust "makes people despondent and dispirited," wrote Mises.

The more optimistic they were under the illusory prosperity of the boom, the greater is their despair and their feeling of frustration. The individual is always ready to ascribe his good luck to his own efficiency and to take it as a well-deserved reward for his talent, application and probity. But reverses of fortune he always charges to other people, and most of all to the absurdity of social and political institutions. He does not blame the authorities for having fostered the boom. He reviles them for the inevitable collapse.

The rationalization that Mises refers to is discussed by social psychologist Daniel Gilbert in his book Stumbling on Happiness. Gilbert explains that our frontal lobes make us look at ourselves through rose-colored glasses: "To learn from our experience we must remember it, and for a variety of reasons, memory is a faithless friend."

"In a world of fiat currencies, created with the ease of keystroke, the value of our savings is threatened every hour of every day."

Psychologists also call this "hindsight bias."

"People distort and misremember what they formerly believed," explains psychologist Daniel Kahneman. "Our sense of how uncertain the world really is never fully develops, because after something happens, we greatly increase our judgments of how likely it was to happen."

This bias keeps us from feeling like idiots as we look back, but unfortunately it "can make you act like an idiot as you go forward," writes Jason Zweig.

The phenomena of cognitive dissonance is another way to look at this. Cognitive dissonance is the mental tension created when a person holds two conflicting thoughts simultaneously. For instance, an investor may have believed the stocks he invested in during the boom would make him rich. But when the bust occurs or the stock prices head south for another reason, the evidence is overwhelming that the investor was wrong. Will he or she admit it? No. "The individual will frequently emerge, not only unshaken, but even show a new fervor about convincing and converting people to his view," psychologist Leon Festinger writes.

When we hang on to losing stocks, unprofitable investments, failing businesses, and unsuccessful relationships, we're experiencing cognitive dissonance — rationalizing our past choices, while unfortunately "those rationalizations influence our present ones," Shermer writes.

"There is need to stress this point," wrote Mises,

because the public, always in search of a scapegoat, is as a rule ready to blame the monetary authorities and the banks for the outbreak of the crisis. They are guilty, it is asserted, because in stopping the further expansion of credit, they have produced a deflationary pressure on trade.

The simple fact is most people just do not have brains suitable for investing. Humans have too many biases — biases that protect us and our fragile egos, so that we can get up and face life each and every day.

But in a world of fiat currencies, created with the ease of keystroke, the value of our savings is threatened every hour of every day. And when monetary bureaucrats act, they send shock waves not only through the financial markets but also through investors' and entrepreneurs' brains, sending the mass investoriat on another chase toward riches that are but a chimera.

"The spiritual dimension of these inflation-induced habits seem obvious," Guido Hülsmann writes in his book The Ethics of Money Production. "Money and financial questions come to play an exaggerated role in the life of man."

But for ordinary citizens to simply put money in a savings account at the local bank is suicidal, as Hülsmann makes clear. "They must invest in assets the value of which grows during inflation; the most practical way to do this is to buy stocks and bonds," he writes.

But this entails many hours spent on comparing and selecting appropriate issues. And it compels them to be ever watchful and concerned about their money for the rest of their lives. They need to follow the financial news and monitor the price quotations on the financial markets.

The rational-expectations and efficient-markets-hypothesis folks think that's just fine; everyone is perfectly rational and have all the information they need to invest without worry. They say market bubbles and the ensuing crashes just aren't possible. Investors know when markets will boom and bust.

Those of us in the Austrian School know better. Booms and busts do happen with all too much regularity in a fiat-money world, inflicting not only financial pain, but emotional and social turmoil as well. Professor Hülsmann points out that

Carpenters, masons, tailors, and farmers are usually not very astute observers of the international capital markets. Putting some gold coins under their mattress or into a safe deposit box saved them many sleepless nights, and it made them independent of financial intermediaries.

That's good advise for all of us.

Douglas French is president of the Mises Institute and author of Early Speculative Bubbles & Increases in the Money Supply. He received his masters degree in economics from the University of Nevada, Las Vegas, under Murray Rothbard with Professor Hans-Hermann Hoppe serving on his thesis committee. See his tribute to Murray Rothbard. Send him mail. See Doug French's article archives. Comment on the blog.

© 2010 Copyright Ludwig von Mises - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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