exposure to stress led participants to choose riskier decisions when trying to decide between taking a minor loss or a major one

TO BE NOTED: From the Economist:

"Psychology and trading

Stress testing

Apr 8th 2009
From The Economist print edition

The crisis is likely to make traders take riskier decisions to avoid losing money

IT HAS long been known in financial markets that people are so reluctant to lose money that they will take big risks to avoid it. If you give the average person a 90% chance of winning a little money or a 10% chance of winning a lot, he will most likely take the option that offers him at least a little bit of cash. But offer him a 90% chance of losing a little money or a 10% chance of losing a lot, and he will opt for the latter. A recent study finds that stress exacerbates this.

Getty Images

My left hand is freezing

Anthony Porcelli and Mauricio Delgado, psychologists at Rutgers University in New Jersey, set out to analyse the sorts of financial risks people were willing to take when calm or stressed. They knew finance could be stressful at the best of times. Stockbrokers, for instance, make important financial decisions in split seconds in conditions that are sometimes noisy, hot and socially tense, they noted in Psychological Science, a journal. Does this affect their judgment?

The experiment involved students playing a gambling game. To stimulate stress, for part of the game half had their main hand in very cold water. The students faced financial decisions that varied in both the degree of risk and the amount of money that could be won or lost. They could choose between, say, an 80% chance of losing 75 cents and a 20% chance of losing $3 or an 80% chance of winning 75 cents and a 20% chance of winning $3. They could keep anything they won.

The psychologists found that exposure to stress led participants to choose riskier decisions when trying to decide between taking a minor loss or a major one. The reverse proved true with gains.

One potential explanation for the effect might be that the human brain has two ways of looking at the world, an analytical one and an intuitive one. The analytical one is more easily disrupted by outside stimuli, such as stress. The intuitive one cuts to the bottom line when times are tough.

Professional traders with years of experience should still make reasonable decisions when forced to respond to situations under stress since their intuitions are well honed. Thus, increasing stress should not disrupt their activities much as long as circumstances are not so unusual that they disturb their intuition.

What is worrying is that today’s traders are in truly uncharted (and very cold) waters, and under such conditions, experience is little help; split-second decisions have to be taken that have never been encountered before. As a result, traders could be vulnerable to the phenomena seen in the study, says Valerie Reyna, co-director of the Centre for Behavioural Economics and Decision Research at Cornell University in New York. Ideally, one way for governments to improve the situation would be to give people a better sense of what is going wrong and how to fix it, explains Ms Reyna. Unfortunately, governments seem to be almost as disoriented as everyone else at the moment. So the traders are likely to take bigger risks to avoid loss, just like the students."

to judge others’ changing thinking, their understandings, their intentions, their pretenses. It is a judgment faculty

TO BE NOTED: From the NY Times:

"It Pays to Understand the Mind-Set

By ROBERT J. SHILLER

IN 1934, the journalist Johannes Steel wrote a remarkably prescient book, “The Second World War,” which described the social psychology that laid the groundwork for global tragedy.

Mr. Steel was trying to peer into people’s minds and infer their actual world views and motivations — in part by examining prewar cycles of social provocation in Germany and Japan and Italy. His timing about the war was wrong — he expected it to start in 1935, not 1939 — but he was correct about many fundamentals. Yet his early readers were often skeptical and blithely assumed that there would be no war.

So it has been with more recent analyses, based in large part on social psychology, foreshadowing the global economic crisis of the current day. No one got it exactly right, but the insights of the approach exemplified by Mr. Steel and used by some analysts today are worth taking very seriously.

Rather than depending exclusively on quantitative analysis, this method relies on a “theory of mind” — defined by cognitive scientists as humans’ innate ability, evolved over millions of years, to judge others’ changing thinking, their understandings, their intentions, their pretenses. It is a judgment faculty, quite different from our quantitative faculties.

In October 1989, I attended a conference at the National Bureau of Economic Research organized by Martin Feldstein, the Harvard economist, on “The Risk of Economic Crisis.” The conference still sticks in my mind because of a paper delivered there by Lawrence H. Summers, now the head of the president’s National Economic Council and the dominant economic intellectual at the White House. During the Clinton administration, Mr. Summers was Treasury secretary and backed legislation that helped deregulate financial markets; many analysts say the policies helped lay the foundation of the subsequent financial crisis. But back in 1989, because of his imaginative work, I came away with a recognition that a severe contraction, even a depression, could indeed come again.

(His and other papers from the conference are at www.nber.org/chapters/c6231.pdf.)

Mr. Summers told a fictional but vivid story of a big financial crisis, complete with examples of specific events and how people might react to them. Seeing it concretized as an imaginary history, and placed in the near future — in just two years, in 1991 — made it seem more real and familiar.

He said that this crisis would be preceded by an enormous stock market boom, bringing the Dow to the unimagined high of 5,400 by October 1991. (The Dow was at 2,600 on the day of the conference; 5,400 would be 13,000 today if scaled up in proportion to gross domestic product.)

Euphoria gripped the investors of his fictional universe. “The notion that recessions were a thing of the past took hold,” Mr. Summers said. He added that over a 15-year period through 1990 — a time that included the 1987 crash — investors earned an average real return of 11 percent. The popular view was that “with a reduced cyclical element, the future would be even brighter.”

Furthermore, he said, “lawyers and dentists explained to one another that investing without margin was a mistake, since using margin enabled one to double one’s return, and the risks were small given that one could always sell out if it looked like the market would decline.”

Today, this sounds like a description of thinking that led to the 2000s boom, although the leveraging of investments tended to take a form other than that of traditional margin credit on stock purchases.

His fictional account went on to describe the early signs of the crisis, “In October 1991, problems began to surface,” he said, adding that a “major Wall Street firm was forced to merge with another after a poorly supervised trader lost $500 million by failing to properly hedge a complex position in the newly developed foreign-mortgage-backed-securities market.” He went on to describe how this provocation led to a change in psychology and a market crash and problems in banks and credit markets.

His fiction concluded, “The result was the worst recession since the Depression.”

How did he write a story 20 years ago that sounds so much like what we are experiencing now? It seems that he was looking at factors of human psychology, much as Mr. Steel did. Mr. Summers evidently knew that an event like our current crisis was waiting to happen, someday.

Ultimately, the record bubbles in the stock market after 1994 and the housing market after 2000 were responsible for the crisis we are in now. And these bubbles were in turn driven by a view of the world born of complacency about crises, driven by views about the real source of economic wealth, the efficiency of markets and the importance of speculation in our lives. It was these mental processes that pushed the economy beyond its limits, and that had to be understood to see the reasons for the crisis.

Of course, forecasts based on a theory of mind are subject to egregious error. They cannot accurately predict the future. But the uncomfortable truth has to be that such forecasts need to be respected alongside econometric forecasts, which cannot reliably predict the future, either.

Still, in our current crisis, we need to try to understand the perils we face. The motivation for a vigorous economic recovery program must come, at least in part, from our forecasts of the dangers ahead. The greatest risk is that appropriate stimulus will be derailed by doubters who still do not appreciate the true condition of our economy.

Robert J. Shiller is professor of economics and finance at Yale and co-founder and chief economist of MacroMarkets LLC."

behavioral finance guy Dan “Predictably Irrational” Ariely on cheating.

TO BE NOTED: From Paul Kedrosky:
Dan Ariely on Cheating

By Paul Kedrosky · Tuesday, March 17, 2009 · ShareThis

This was a thoughtful, funny and surprisingly moving talk at this year year’s TED Conference: behavioral finance guy Dan “Predictably Irrational” Ariely on cheating.

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"The logical implication is that a mixed economy will outperform both central planning and laissez faire"

John Quiggin reminds me of Jimi Hendrix pronouncing Surfer Music dead:

"Refuted economic doctrines #1: The efficient markets hypothesis

By jquiggin | January 2, 2009

I’m starting my long-promised series of posts on economic doctrines and policy proposals that have been refuted or rendered obsolete by the financial crisis. There will be a bit of repetition of material I’ve already posted and I’ll probably edit the posts in response to points raised in discussion.

Number One on the list is a topic I’ve covered plenty of times before (in fact, I was writing about it fifteen years ago), the efficient (financial) markets hypothesis. It’s going first because it is really the central microeconomic issue in a wide range of policy debates that will (I hope) be covered later in this series. Broadly speaking, the efficient markets hypothesis says that the prices generated by financial markets represent the best possible estimate of the values of the underlying assets."

Here's where I stand. I propound a form of Behavioral Finance:

(((((("Criticism and behavioral finance

Price-Earnings ratios as a predictor of twenty-year returns based upon the plot by Robert Shiller (Figure 10.1,^[11] source). The horizontal axis shows the real price-earnings ratio of the S&P Composite Stock Price Index as computed in Irrational Exuberance (inflation adjusted price divided by the prior ten-year mean of inflation-adjusted earnings). The vertical axis shows the geometric average real annual return on investing in the S&P Composite Stock Price Index, reinvesting dividends, and selling twenty years later. Data from different twenty year periods is color-coded as shown in the key. See also ten-year returns. Shiller states that this plot "confirms that long-term investors—investors who commit their money to an investment for ten full years—did do well when prices were low relative to earnings at the beginning of the ten years. Long-term investors would be well advised, individually, to lower their exposure to the stock market when it is high, as it has been recently, and get into the market when it is low."^[11] This correlation between price to earnings ratios and long-term returns is not explained by the efficient-market hypothesis.

Investors and researchers have disputed the efficient markets hypothesis empirically and theoretically. Behavioral economists attribute the imperfections in financial markets to a combination of cognitive biases such as overconfidence, overreaction, representative bias, information bias, an inability to use configural rather linear reasoning, and various other predictable human errors in reasoning and information processing. These have been researched by psychologists such as Daniel Kahneman, Amos Tversky, Richard Thaler, and Paul Slovic. These errors in reasoning lead most investors to avoid high-value stocks and buy growth stocks at expensive prices, which allow those who reason correctly to profit from bargains in neglected value stocks and the overreacted selling of growth stocks.

Empirical evidence has been mixed, but has generally not supported strong forms of the efficient markets hypothesis^{[3] [2]} low P/E stocks have greater returns. In this paper he also refuted the assertion by Ray Ball that these higher returns could be attributed to higher beta,^[12] whose research had been accepted by efficient market theorists as explaining the anomaly^[13]:151 in neat accordance with modern portfolio theory.

Speculative economic bubbles are an obvious anomaly, in that the market often appears to be driven by buyers operating on irrational exuberance, who take little notice of underlying value. These bubbles are typically followed by an overreaction of frantic selling, allowing shrewd investors to buy stocks at bargain prices. Rational investors have difficulty profiting by shorting irrational bubbles because, as John Maynard Keynes commented, "Markets can remain irrational longer than you can remain solvent." Sudden market crashes as happened on Black Monday in 1987 are mysterious from the perspective of efficient markets.

Another anomaly exists in the form of the investors who beat the market soundly on a long-term basis, including Peter Lynch, Warren Buffett, George Soros, and John Templeton. Warren Buffett has commented that "I'd be a bum on the street with a tin cup if the markets were always efficient".

Burton Malkiel, a well-known proponent of the general validity of EMH, has warned that certain emerging markets such as China are not empirically efficient; that the Shanghai and Shenzhen markets, unlike markets in United States, exhibit considerable serial correlation (price trends), non-random walk, and evidence of manipulation.^[14]

Behavioral psychology approaches to stock market trading are among some of the more promising alternatives to EMH (and some investment strategies seek to exploit exactly such inefficiencies). But Nobel Laureate co-founder of the programme—Daniel Kahneman—announced his skepticism of investors beating the market: "They're [investors] just not going to do it [beat the market]. It's just not going to happen."^[15] Richard Thaler has started a fund based on his research on cognitive biases. In a 2008 report he identified complexity and the herd behavior as central to the global financial crisis of 2008.^[16]"))))))

Back to Quiggan:

"The hypothesis comes in three forms.

The weak version (which stands up well, though not perfectly, to empirical testing) says that it is impossible to predict future movements in asset prices on the basis of past movements, in the manner supposedly done by sharemarket chartists. While most of what is described by chartists as ‘technical analysis’ is mere mumbo-jumbo, there is some evidence of longer-term reversion to mean values that may violate the weak form of the EMH.

The strong version, which gained some credence during the financial bubble era says that asset prices represent the best possible estimate taking account of all information, both public and private. It was this claim that lay behind the proposal for ‘terrorism futures’ put forward, and quickly abandoned a couple of years ago. It seems unlikely that strong-form EMH is going to be taken seriously in the foreseeable future, given the magnitude of asset pricing failures revealed by the crisis.

For most policy issues, the important issue is the “semi-strong” version which says that asset prices are at least as good as any estimate that can be made on the basis of publicly available information. It follows, in the absence of distorting taxes or other market failures that the best way to allocate scarce capital and other resources is to seek to maximise the market value of the associated assets. Another way of presenting the semi-strong EMH is to say whether or not markets are perfectly efficient, they’re better than any other possible capital allocation method, or at least, better than any practically feasible alternative."

Here's a similar list and explanation:

(((((("There are three common forms in which the efficient-market hypothesis is commonly stated — weak-form efficiency, semi-strong-form efficiency and strong-form efficiency, each of which have different implications for how markets work.

[edit] Weak-form efficiency

• Excess returns cannot be earned by using investment strategies based on historical share prices.
• Technical analysis techniques will not be able to consistently produce excess returns, though some forms of fundamental analysis may still provide excess returns.
• Share prices exhibit no serial dependencies, meaning that there are no "patterns" to asset prices. This implies that future price movements are determined entirely by information not contained in the price series. Hence, prices must follow a random walk.

[edit] Semi-strong-form efficiency

• Semi-strong-form efficiency implies that share prices adjust to publicly available new information very rapidly and in an unbiased fashion, such that no excess returns can be earned by trading on that information.
• Semi-strong-form efficiency implies that neither fundamental analysis nor technical analysis techniques will be able to reliably produce excess returns.
• To test for semi-strong-form efficiency, the adjustments to previously unknown news must be of a reasonable size and must be instantaneous. To test for this, consistent upward or downward adjustments after the initial change must be looked for. If there are any such adjustments it would suggest that investors had interpreted the information in a biased fashion and hence in an inefficient manner.

[edit] Strong-form efficiency

• Share prices reflect all information, public and private, and no one can earn excess returns.
• If there are legal barriers to private information becoming public, as with insider trading laws, strong-form efficiency is impossible, except in the case where the laws are universally ignored.
• To test for strong-form efficiency, a market needs to exist where investors cannot consistently earn excess returns over a long period of time. Even if some money managers are consistently observed to beat the market, no refutation even of strong-form efficiency follows: with hundreds of thousands of fund managers worldwide, even a normal distribution of returns (as efficiency predicts) should be expected to produce a few dozen "star" performers."))))))

Back to Quiggan:

A Review Of "Nudge"

Will Wilkinson reviews the book "Nudge" on Reason. The conclusion:

"All Nudge really offers is the idea that we should use what we know about how people act in order to design policy that will help them. And we shouldn't take away their choices. Well, I'm for all of it. If some policy makers really are misled by unrealistic economic models of rationality, then they should cut it out and bone up on psychology. Behavioral economics provides valuable new information about what will and won't work, and why. Thaler's work on savings plans is a great example of what can be done by taking into account new findings in psychology.

But it's no source of ideological realignment, no basis for what Thaler and Sunstein call a "Real Third Way." This book offers some whiz-bang behavioral economics that can be used for any ideological end, and it gives us the agreeably banal doctrine of choice-preserving helpfulness. The whiff of paradox in "libertarian paternalism" may have set up hopes for a category-defying revolution, but Nudge is the book where those hopes, and that tiny monster of an idea, prove flightless."

I consider Sunstein and Thaler to be proponents, more or less, of my agenda, so I'm going to have to read the book myself. However, Wilkinson does make some good points.