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.
Humanities & Social Science
Comments (8)
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.
Posted by: AngryNerdMan | September 19, 2008 10:56 AM