Thursday, October 16, 2008

Irrational markets, loss aversion and financial crisis

The recent financial crisis is big news these days. What insights does psychology have with regards to the fear and irrationality pervading Wall Street and the financial markets?

People are not rational

Despite the drastic moves by central banks to unfreeze credit, the overall sentiment in the market still remains fearful (though there seems to be some abatement in the rampant fear). Investors had escaped the stock market en masse when it seems that even banks are not longer secure institutions against the stock crash. Even markets (like Japan) seemingly uninvolved in the crisis also fell.

Economists have always made the basic assumption that humans are rational. Yet, psychologists would have told you that this is not the case. People make irrational choices. Given the same expected value, people would much rather avoid losing than press on their chances for gaining.

Would you rather win $900 or have a 90% chance of winning $1000?
Answer this before going on to the next question.
Would you rather loss $900 or have a 90% chance of losing $1000?

Rationally, a person who rather wins $900, should answer "rather loss $900" - the amount of certainty correlates with each other. A person who can handle risk would choose "90% chance of winning $1000" and "90% chance of losing $1000".
Yet, what is found is that a normal person would choose a certain win of $900 and 90% chance of losing $1000. In both cases, the expected value is the same, but the results differ.

People have a more intense reaction to loss compared to gain. - Loss aversion
As such, when investors saw the dive in the stock markets, their immediate reaction is to limit their losses. It does not matter if rationally, their investments are secure or that the investments are unrelated to the crisis or that holding out for the long run would probably mean a return of their stock values. The intense reaction to loss (loss aversion) would have activated their fear response: fight or flight. In this case, many chose flight.

For investors, they would rather sell at low value instead of holding on to their stocks and risk possible zero value (in face of bankruptcy by financial institutions or companies)
For banks, they would rather hoard cash and avoid any possible loss instead of seeking any possible gain by lending.
In both cases, loss aversion contributes to the credit freeze and stock crash.

Prospect Theory
The above questions was actually part of the experiment conducted by Kahneman and Tversky (1979). They came up with a theory about decision-making called the prospect theory. One assumption is loss aversion: the extent of bad feeling in losing $900 is greater than the happiness obtained in winning $900, so people try to avoid a certain loss of $900 by gambling for a 90% chance of losing $1000.
~note: Kahneman won the Nobel prize for Economics. He applied the prospect theory to economic thinking

Kahneman, D. & Tversky, A. (1979). Prospect theory: An analysis of decisions under risk.
Econometica, 47, 263-291.

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