The Frontal Cortex

Emotional Investors

Wall Street sure is moody. Forty-eight hours ago we were on the verge of a financial apocalypse. Now, traders are engaging in record breaking market surges. While there certainly has been lots of news that helps explain these dramatic shifts, I wonder if a significant part of the movement is actually rooted in the raw emotions of investors.

In 2001, MIT professor Andrew Lo wanted to shed some light “on the longstanding controversy in economics and finance of whether financial markets are governed by rational forces or by emotional responses.” He wired 10 currency speculators and stock traders at a brokerage firm with sensors monitoring their heart rate, blood pressure, body temperature and skin conductivity. These bodily symptoms correlate with our emotions: intense feelings make for fast pulses. By the end of the day, the traders had made more than a thousand financial decisions, wagering over forty million dollars. If these professional investors were perfectly rational agents, then they should have had perfectly calm bodies. When Lo looked at the data, however, he found that the decisions of the traders were the stuff of sweaty palms and spiking blood pressure. Most financial transactions were accompanied by a surge of feeling.

This wasn’t necessarily a bad thing. The vast majority of emotional decisions turned out to be profitable. Just because a trader had nervous hands didn’t mean they were acting “irrationally”. As Lo notes:

Our results may surprise some financial economists because of the apparent inconsistency with market rationality, but a more sophisticated view of the role of emotion in human cognition can reconcile any contradiction in a complete and intellectually satisfying manner. Emotion is the basis for a reward-and-punishment system that facilitates the selection of advantageous behavioral actions, providing the numeraire for animals to engage in a ”cost- benefit analysis” of the various actions open to them. From an evolutionary perspective, emotion is a powerful adaptation that dramatically improves the efficiency with which animals learn from their environment and their past.

Let’s just hope that this good mood reflects an underlying reality and isn’t merely yet another burst of irrational exuberance.

Comments

  1. #1 AngryNerdMan
    September 19, 2008

    of course it is. the market is never very irrational. how can the financial status of the country have improved when bailouts occurred and governments all over the world probably saw their deficit increase.

    the market has bipolar.

  2. #2 AngryNerdMan
    September 19, 2008

    irrational=rational

  3. #3 OneEyedMan
    September 19, 2008

    Perhaps you saw the article in slate: Stress and Class: An NYU sociologist claims, preposterously, that it’s more stressful to be rich than poor.

    It cited a study of job stress:
    “Tierney reported that scientists at the New York Hospital-Cornell Medical Center’s cardiovascular center had hooked up two people in high-stress jobs to a device that measured their blood pressure every 15 minutes. One was a 48-year-old Caucasian named Gianni Fidanza who worked on Park Avenue as a stockbroker. The other was a 34-year-old African-American single mother named Cathy Collins who worked at New York Hospital as a clerical aide.

    By mere happenstance, the day chosen to record for posterity Fidanza’s varying blood pressure was Oct. 19, 1987 (“Black Monday”). On that day, the stock market set a record for the largest one-day percentage decline: The Dow fell 508 points, or 22 percent. In all likelihood, it was the most stressful day Fidanza ever experienced in his working life. The day chosen to record Collins’ blood pressure, meanwhile, was “a perfectly ordinary Wednesday.” Yet during their respective workdays, the increase in blood pressure experienced by Fidanza as he watched the stock market crash matched that experienced by Collins as she went about her daily chores. And while Fidanza’s blood pressure dropped back to normal once he got home, Collins’ rose 10 percent after she returned home and started tending to her two children.”

    If being a broker is at worst as stressful as being clerical aide, a job where people rarely let their emotions get the best of them, then could reasonably be expected to experience the emotion without letting it cloud their judgment much.

  4. #4 Ren Galskap
    September 19, 2008

    ‘In 2001, MIT professor Andrew Lo wanted to shed some light “on the longstanding controversy in economics and finance of whether financial markets are governed by rational forces or by emotional responses.” He wired 10 currency speculators and stock traders at a brokerage firm with sensors monitoring their heart rate, blood pressure, body temperature and skin conductivity.’

    There are three problems with this. First, he wanted to test whether markets (aggregate behavior) are rational, but he tested individuals. Second, he tested for physiological evidence of emotional response, not for rationality. One can have a strong physiological response to circumstances and still act rationally. Third, you don’t indicate that he defined what rational behavior is. Or more importantly, what lack of rational behavior would be. If you don’t know what you’re looking for, you don’t have any way of knowing whether you’ve found it.

    All he demonstrated was that people involved in daily trading operations get excited. I think we already knew that.

  5. #5 joe
    September 19, 2008

    If you can call greed an emotion, then yes: A significant part of the current volatility is due to “emotions”. It may be wise to keep in mind that those individuals that are responsible for the current situation (banking CEO�s, insurance CEO’s, the CEO’s of Freddy Mac and Fanny Mae, lobbyists, members of the legislative branch) have done just fine for themselves, whatever happens to the markets. It�s the U.S. taxpayer and his descendants that are taken to the cleaners. The little guy that has no lobby.
    That�s why the investor class is currently rejoicing and stocks are back up to where they were at the beginning of the week: They have found someone who will pay their future dividends, bonuses and salaries. And guess what, it�s you and me. Happy day!

  6. #6 Richard Eis
    September 19, 2008

    Yknow, it wasn’t until this moment that i realised…we don’t have a financial scientist…if there is such a thing..why…. because finances aint interesting to scientists i suppose. There is a maths blogs and some other coverage…but….

    Considering the importance of money i find it surprising that science has little to say on the matter except for overlapping disciplines.

    Yet money holds a huge sway over our lives…barely understood, barely noticed…always a factor in any decision…yet science has little or nothing to say about it apparently….

    i would love to learn about finances…but i don’t know where to start….
    please include a finances blog for us. To help us in our hour of need.

  7. #7 Sundeep
    September 19, 2008

    joe, greed? You mean the desire to want as much as possible for oneself? Isn’t that a basic desire for everyone? Wouldn’t wanting less than what one could get be irrational?

    It’s ridiculous to think of CEOs as doing just fine. Surely, they would want more employment as opposed to less. The investor “class” has borne a large part of the loss, given that shareholders of Bear Stearns, Lehmann and AIG were or will be essentially wiped out. That’s huge no matter how you cut it. The issue for taxpayers is whether bailing out was the lesser of two evils. There are costs to inaction as well.

    Richard, how would you classify (financial) economics then, if not the (social) science of finance?

    On the topic of the post, however, I agree with Ren. I wonder if there is a similar study which uses lower values for decisions, given that $40 million was at play here, as I wonder if the size of the decision played a part.

  8. #8 negentropyeater
    September 20, 2008

    Gee, I’m always amazed at how nave some comments are about the current situation.

    It’s actually fairly simple :

    Households in the US have too much debt (subprime, near prime, prime mortgages, home equity loans, credit cards, auto loans and student loans) while their assets (values of their homes and stocks) are plunging leading to a sharp fall in their net worth. And households are getting buried under this mountain of mounting debt and rising debt servicing burdens. Thus, a fraction of the household sector as well as a fraction of the financial sector and a fraction of the corporate sector and of the local government sector is insolvent.

    Now what do you do when you have too much debt ? You work harder, and save to pay back your debt. That’s the only way to get out of it. And during that time, you will automatically have a severe economic recession. There’s NO WAY around it. NO CLEVER accounting trick, no calling God for help, nothing.

    What the govt is doing is the opposite, increasing the debt, so that’s obviously not going to solve the problem is it ?

    If there’s been a short term rise the last two days, it’s because the govt has anounced that it will purchase some of the worst assets of failed institutions on the market (an RTC like instituion) which means parking some of the worst debt away from the capital markets, so obviously, they rise.

    Obviously, that doesn’t solve anything, the situation is still as catastrophic. Within a few weeks, the markets will come tumbling down again, guaranteed.

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