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Wednesday, 25 February 2015

Novelty, Unicorns and the Stressed Investor

Bad Hair Days

There’s a Groundhog Day effect in financial markets: wait long enough and another crisis will occur and everyone will be stunned and surprised. In fact they’ll be just as stunned and surprised as they were the last time one occurred. We’ve the attention span of a distracted goldfish when it comes to noticing the disconcerting regularity of market mishaps.

But although market upheavals are frequent they’re not so frequent that we get used to them. The steady state is a constant background hum of noise punctuated by occasional bouts of excitement over some stock or other. When a crisis occurs it’s a novelty – and for most of us our response to novelty is to get stressed, and then run around like our hair is on fire. By and large, I'd observe, this is not optimal investing behavior.

Lost Unicorns

There’ve been lots of studies about financial panics, many of which focus on the inherent instability of markets and the way in which actors in the market – that’s us, by the way – can cause crises merely by behaving in a depressingly familiar way: we get overly excited and cause a bubble and then overly depressed and cause a crash. As we’ve seen here many times, humanity carries with it a wide range of mental tics and unconscious twitches, which can interact in the most delightful fashion: if you’re not invested, that is.  If you are it all tends to be a bit stressful.

In fact, despite the best efforts of economists, we’re still more likely to stumble over a unicorn drinking from the fountain of youth than we are to predict the next financial boom and bust. This is distressing for practitioners, because the pesky things do rather make a mess of the nice mathematical models used to manage the world’s money; and, of course, they make a lot of economists look like idiots.  Readers here won’t be shocked to learn that the increasing evidence from behavioral finance that investors may not be entirely rational has led some economists to reckon that it’s all that irrationality that makes predicting market crashes impossible.

Mental Avalanches

But while we often focus on the psychology of investors there’s a rather more straightforward fact underpinning this behavioral flim-flam: we’re animals and much of our behavior isn’t determined by our higher cognitive functions, willpower or positive thinking but by biology.  Like it or not our physiology isn’t something that we can change, we’re born with it, we have to live with it and, for the most part, we’re not even aware of it. And perhaps it’s this underlying biological determinism that makes market crises so inevitable – and if it is then perhaps they’re not so unpredictable after all.

One the odder things about the irregular booms and busts in markets is the implication that somehow we’re all synchronizing our behavior. On the face of it this looks like we’re copying each other, but somehow the whole process creates some kind of group mental avalanche. One idea is that there’s a hidden third variable that causes us to all respond in a similar way – the idea that there are specific market signals that we’re conditioned to respond to (see Y is for Yawn Effect).

Novel Stress

However, it may be that there’s a deeper, and simpler, explanation: we suffer from an innate stress response to novelty.  This is the idea discussed by Alexey and Petr Sarapultsev in Novelty, Stress, and Biological Roots in Human Market Behavior:
From a biological point of view, human behaviors are essentially the same during crises accompanied by stock market crashes and during bubble growth when share prices exceed historic highs. During those periods, most market participants see something new for themselves, and this inevitably induces a stress response in them with accompanying changes in their endocrine profiles and motivations. The result is quantitative and qualitative changes in behaviour.
In essence, novelty causes stress and stress causes us to behave differently from the way that we do in more normal, less novel, situations. It’s important to note that “stress” here is relative – all decisions cause us some level of stress, but those under conditions of uncertainty seem to trigger more extreme reactions, by excessively activating specific areas of the brain that seem to be implicated in heightening irrational behavior.

Life, Death and Investors

Quite why stress would cause us to behave irrationally isn’t entirely clear but there’s a clue in a study by Anthony Porcelli and Mauricio Delgado, Acute Financial Risk Modulates Risk Taking in Financial Decision Making. They observed that:
“The reflection effect—where people make risky decisions in the loss domain but conservative decisions in the gain domain—was significantly increased under stress … it may be that, under stress, people come to rely more heavily on automatized risk biases—exacerbating already prevalent domain-dependent decision-making preferences. If stress interferes with processing resources required by the brain’s executive systems, it is plausible that this would lead to an exaggerated reliance on lower-level automatized systems”
This suggests that people under stress seem to be inclined to take more risks and rely less on higher cognitive processes and more on underlying automated neural systems for decision making – which is exactly the kind of response you’d expect in fight or flight situations, where the need to react quickly can be the difference between life and death. Most likely novelty in markets is triggering deep physiological processes that are inappropriate to the circumstances.

Novel Situations

The net result of this is that the way that investors behave during crises and bubbles is different from the way that they behave in more normal times. Placed under stress by the novelty of the situation we behave less rationally and more reactively than we do at other times. Which explains why we seem to get mass market delusions across ranges of investors, because the underlying physiological mechanisms are common to us all.

Once the triggers are in place and the market is moving then a whole range of other factors come into play. Momentum investing, as both professional and private investors play the Greater Fool game can lead to ridiculous valuations for both individual stocks and markets – although there’s never any shortage of apologists explaining why it’s different this time.  Of course, it never is, it's just the new normal, not novel situation - until it isn't any more, and everything goes into reverse.

Weepy Investors

The idea that a lot of our behavior is determined by our biology sits uncomfortably with the Western idea of self-determination, the belief that each of us thinks and acts independently. But really it shouldn’t be much of a surprise that we’re similarly affected by similar conditions; in fact it’s more puzzling that more attention hasn’t been paid to the concept.  I suspect that most of the behavioral biases that I’ve discussed here will eventually be found to be based in very old physiology rather than higher levels of psychology.

Still, even recognizing that people are not the same under novel conditions as they are under steady-state ones is an important insight – we can do all the clever studies we want of people in the latter state without gaining very much understanding of what they’re going to do in the former one. Though personally I doubt that we’ll ever be able to effectively model and predict the market until we stop people trading, and replace them with something less inclined to get weepy over soap operas.

The reflection effect added to The Big List of Behavioral Biases.

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