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Rational Markets and Irrational Traders

“Traders and rodents…seem to have something in common.”The Economist

Image of the human head with the brain. The ar...

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If you’re in the current cool-crowd of psychology, you are probably a cognitive psychologist. Interest in, and funding for, cognitive psychology has greatly increased over the last fifteen to twenty years. This is due in part to popular authors like Gladwell and Daniel Pink bringing public awareness to new discoveries about how the mind forms conclusions. This has popularized cognitive and neurological perspectives in other fields of study as well.

One very interesting field that has surfed on the wave of cognitive psychology is behavioral economics. Behavioral economics studies the cognitive and emotional – that is to say the irrational – decision factors of an area that has been traditionally understood as completely rational.

Market participants like consumers, investors and bankers typically think of themselves as analysts. They’re job is to study information and make an informed decisions as to whether a certain product of instrument is worth of investment. Understanding their function in this way, participants are quick to credit their own powers when transactions turn out favorably.

Two recent articles from The Economist paint a more interesting picture: one of influential market actors as hormone-drenched, delusional, cognitively disconnected impulse-actors who have a biased understanding of their own abilities and track record.

The first article is “Raging Hormones.” It details the work of a Cambridge neuroscientist named John Coates who studies the biochemistry of market traders. According to the article, Coates’ work “suggests that hormones drive investment decisions to a far greater extent than economists or bank executives realize.”

Cortisol, in 3D

One example of this is the fluctuation in serum cortisol levels in equity traders’ blood. In a recent post, I discussed the roles of adrenaline and cortisol in the bloodstream, and their roles in dealing with stress triggers. While conducting experiments on a London trading floor, Coates saw cortisol levels in traders saliva jump as much as 500% over the course of a day. In fact, it rose in direct correlation with the market’s current implied volatility. Cortisol is the hormone that’s part of a primal early warning system; among other things, it causes feelings of dread. When it enters the blood, it would cause an irrational tendency towards risk aversion. Chronic high levels can lead to paranoia.

Another article, “The Irrationality of Politics,” uses the principles of behavioral economics to explain voter preferences, as those preferences arise from the same kind of economic irrationality. The article highlights three principles within behavioral economics that apply just as much to politics as they do to market trading:

Loss Aversion There’s a longstanding axiom called “prospect theory” which holds that people are more sensitive to losing what they already have than they are to the prospect of new gains. For example, in a recent election, many well-off voters withdrew their support for a conservative candidate who wanted to get rid of certain short term tax credits, even though a conservative government would be the most likely to cut the voters’ overall taxes in the long run. The votors simply did not want to feel the acute sting of immediate loss. Prospect theory is generally healthy for us because the principle keeps us from taking too much financial risk.

Cognitive Dissonance

Cognitive Dissonance It is possible for people, and entire electorates, to hold two different and contradicting views on an issue depending on how that issue is framed. This article cites the issue of inheritance (“death”) tax. Pollsters noticed that the voters responded positively to the idea of raising the tax threshold, because they view the tax as an inherently unfair one. However, the electorate also responds positively to attacks on the idea of raising that same threshold, as a give-away to the rich during recessionary times. There are many market-related examples of cognitive dissonance, and they usually come about as issues get more complex. For example, during the height of the housing bubble, CDO tranches filled with toxic subprime mortgages continued to receive triple-A ratings, leading to a huge amount of dissonance in terms of the value of those securities. That dissonance was a major contributor to the market’s bubble and subsequent downfall.

Instant Judgement – As this article calls it, the “Gladwellian Blink Test.” Malcolm Gladwell wrote in his famous book Blink about the rapid mental processing and judgement that takes place at the instant of introduction to something new. Psychologists believe that much voter and market decision making is based on this kind of rapid, subconscious processing, and that the process that we call rational decision-making merely serves to reverse-justify the instant judgement to which we have anchored ourselves.

Many economic assumptions, including the assumption of Market Discipline, are based off of the concept of the free market as a series of fundamentally rational transactions. As we now look back at the reasons why market discipline failed to head off The Great Recession, we must ask ourselves whether this principle is capable of mitigating systemic risk given what we are learning about how the market actually makes its decisions.

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