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Chronicle of a Bubble Foretold: The Psychology of the Naïve Investor

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Oren KaplanProf. Oren Kaplan (Ph.D.) is a clinical psychologist, economist and a graduate in business administration, Dean of the School of Business Administration at the College of Management, Israel, and has been directing the MBA Management & Business Psychology Program of the school since 2003.
The following paper includes of summary and integration of several 2004 published articles of Prof. Kaplan in Hebrew.

Contact: oren@psychologia.co.il +972-548181849
The Self-Persuasion Effect

                                      Today’s “small investor” faces a complicated problem. The low interest rates made the market’s conservative savings alternatives unattractive. The most attractive short-term venue seems to be the stock market, which rose recently by tens of percents. Yet, as a result of the dramatic stock market crash that occurred when the high-tech bubble burst, and the many other crashes that preceded it, a large part of the general public stays on the sidelines, afraid to be caught in the whirlwind of losses. Nonetheless, it appears that naïve investors seeking investment venues and wishing “to take part in the game” are returning to the stock market. History demonstrates that the less sophisticated and less professional an investor is, the more he panics when he loses and tends to exit the market as a result. His next entry will only take place after the market has risen significantly, and in fact, he loses the large profit advantage that professional investors usually enjoy. Naïve investors join the market along with the crowd for a certain time period, and they suffer the big losses during future market corrections. The causes of these processes will be discussed below.

The naïve investor believes that the “majority rules,” i.e., if the market is rising now, then this is the right time to join. He is unfamiliar with economic data and cannot analyze them. He is blinded by the large amounts of money flowing into the market, and he wants a piece of the pie. I do not claim it is too late to join now since experts claim the market is still on the rise and still has a long-term growth forecast. However, no one can guarantee the growth rate nor predict a reversal of trends. The naïve investor has a short memory and believes that recent trends will remain unchanged, at least in the near future. He realizes that the distant future may bring significant changes, but he (wrongfully) believes that he has the ability to predict them and react quickly enough to avoid a nosedive. The error in judgment is twofold. First, the sense of predictability – the feeling that last year’s market gains indicate that the market will continue to rise at the same rate the following year – is an illusion.

Assume our investor invested his savings of $100,000 and he expects to earn $50,000 at the end of the year because the market rose about 50% in the past year. But is he psychologically ready to lose $50,000 as well? Realistically, the loss is just as likely as the profit. This is where the second error in judgment comes in. Most naïve investors would say irrevocably that they are not willing to take this risk, but at the same time, they would refuse to realize that this is a realistic, possible event. Psychological research shows that people believe that the likelihood that something good would happen to them is higher than the norm. Conversely, they estimate that negative events are less likely than their normal occurrence, thinking, “It won’t happen to me.” People buy lottery tickets because they feel they can win, but they won’t slow down their car because they don’t believe they will be killed in an accident. Sadly, the probability of the second event is much higher than that of the first.

This phenomenon was explained by Festinger’s Cognitive Dissonance theory. Festinger described an anthropological incident that occurred among cult members about 50 years ago. The cult believed that the world was coming to an end. When the world remained standing on the predicted catastrophic date, the believers credited the world’s survival to their strong belief. Since then, the term “cognitive dissonance” describes situations where people who formed a certain opinion and act accordingly, find it hard to admit their mistakes and they use self-persuasion to distort reality. They actively seek information that supports their position, and avoid information that contradicts it. In financial investments, this tendency causes people to disregard the possibility of loss. For example, the investor recognizes the past cases in which stocks rose similarly to the current situation, but he unconsciously ignores similar situations that led to a drop.

To illustrate, recently the euro-dollar exchange changed direction and decreased from a maximum rate of USD 1.37 per euro to a rate of 1.20 within a very short time. Since the euro was on the rise for a long time, the foreign currency trader who invested in euros was supposed to specify a certain rate where he would admit that the tendency turned around. At this point, despite incurring some depreciation, he would “get out of the game” (This point is known as “Stop Loss,” the point at which one cuts his losses, e.g. USD 1.30 per euro). However, at this stage, cognitive dissonance comes into play. The investor is convinced that his initial investment was right, and that the euro is merely correcting its rate downwards. He hopes the rate will improve shortly and generate handsome profits. Yet the rate keeps dropping, and after a few hours or days the naïve investor finds himself at a great loss, several times higher than it was at the beginning or in the middle of the drop. Worse, it is several times higher than the sum he was psychologically ready to lose in the first place. In similar fashion to compulsive gamblers, these situations cause non-professional investors grief, anxiety and depression. They cannot handle the enormous loss of their savings, earned not in effortless speculation, but through months or years of hard work. A series of psychological tendencies prevent the naïve investor from acting according to a reasonable pre-planned trading strategy. He uses rationalization and distorts reality in order to stick to his original position (e.g., that the euro would rise) and holds the biased belief that “lady luck is on my side.” Ignoring relevant information impairs any decision making process. It is often related to what is known as “the basic attribution error” – the tendency to attribute behavior to internal factors rather than to external factors. People are convinced that their positions are correct and influence reality; they are unwilling to accept that the environment has changed enough to justify a change of position and behavior. Notably, prone gamblers and risk-takers are likely to be the most severe losers since their tendency to distort reality in favor of the gamble is worse than that of the traditional risk-evaders. The famous author Dostoyevsky described it well in his book "The Gambler". He wrote about a gambler that played the roulette but did not take up his winnings again and again, until he lost everything all at once. Naïve investors tend to lose money because they don’t ration a limited portion of their total assets to an individual risky investment. Instead, they let their assets grow with the profits and even loan money for additional speculative investments. When a correction occurs, it immediately erases all the profits earned, as well as a significant portion of the investor’s total assets.

 

Mass Psychology

So far, I have dealt mainly with the psychology of the individual investor. This is the place to discuss the influence of mass psychology on stock price fluctuations and other financial investments. The basic laws of supply and demand are taught in introductory economics. Economists add, in parentheses, several psychological factors that may shift equilibrium prices up or down. These factors cause fluctuations in financial markets and limit their predictability significantly. Rumors and expectations affect the market’s price fluctuations, as can be seen in the following example from the foreign exchange market. In this example there were no significant changes in interest rates or other macro-economic factors in this market, and therefore, according to basic economic logic, nothing was supposed to change. And yet, rumors and quotes from financial leaders caused significant fluctuations.

Four days later, March 6th 2004: Great disappointment in the U.S. Only 21,000 jobs were added to the job market. Early estimates were for an addition of 125-130,000 new jobs.

March 2nd 2004: The dollar rises compared to the euro based on estimates that economic growth in the U.S. improves the employment market and encourages the Federal Reserve to raise interest rates this year. Concurrently, interest rates were estimated to drop in the euro zone. The U.S. government may report this Friday that more new jobs were added to the market than in any other month since November 2000.

 

The severity of these fluctuations results from a combination of two factors. One is psychological and the other is technological. Psychologically, “mass hysteria” creates mass reactions in the financial world, similar to that of a crowd in a smoky movie theater that tramples people in a desperate effort to escape from the burning building. After a mass exit from the stock market, there are often opportunities for attractive returns on financial products, since a drastic price drop is usually followed by an upward correction. However, naïve investors, who are normally risk-evaders, must take special precaution at these decisive points until the trend stabilizes and the standard deviation of the market’s performance decreases, for it may be the beginning of an even more dramatic crash. The second influential factor is technological. Today, automated decision robots perform transactions, buying or selling stocks at certain predetermined prices that are considered profit and loss limits. Since many of the financial robots are programmed similarly, their action results in a domino effect that magnifies rises or drops in the market.

 

"Everything is Relative"

The U.S. published its Gross Domestic Product at the end of April 2004. The data showed that growth had reached a high unmatched in 20 years. Yet the markets were disappointed and the dollar collapsed around the world. The reason for the disappointment was that the GDP was expected to rise 5%, and in practice it rose “only” 4.2%. A rational consideration of the data should have resulted in a strengthening of the dollar since the figures unequivocally signify a positive turn in the American economy. However, the expectation for an even higher achievement eventually led to the opposite result in the markets. This psychological phenomenon is related to an innate human characteristic that is also imprinted in the human’s physiological system: the tendency to perceive the world relatively and not absolutely. Analogically, a tiny candle in a dark cave would seem incredibly luminous, whereas it would not even be seen in a well-lit room. This trait promotes survival by allowing us to differentiate between important and trivial matters. Yet in certain situations, it significantly distorts our perception of reality. Kahneman and Tversky’s classic example demonstrates people’s attitude toward discounts: A man arrives at a certain store to buy a product at a fairly low price, say $20. He is told that if he goes to another store in the same chain, a few minutes’ walk away, he can get the same product at a $5 discount. Many people are willing to go to this effort to receive a 25% discount. However, if the product had cost $120, most people would refuse to go to these lengths and give up the 5$ discount because it is too low compared to the product’s price. There is no economic sense in this decision because people’s income sources are absolute, not relative. Usually, a person’s salary is either fixed annually or based on an hourly rate. Either way, these values are fixed. Rationally, the value of money should be identical in any situation, based only on the amount of time invested in earning it. The irrationality demonstrated by Kahneman and Tversky leads people to compromise large sums of money when making major economic decisions, such as buying a car or an apartment, since seemingly, these amounts are less noticeable. Paying $255,000 instead of $250,000 for a house for example, sounds like a minor difference. Yet this $5,000 difference could be several weeks or months’ worth of salary; much effort was invested in earning it, and in any other situation it would not have been given up so easily.

It is important to note that relative profit and relative loss are not perceived with the same intensity. The larger a gain, the lower its value. For example, the first million offered prize in a lottery would draw many more participants than the shift from a one-million to a two-million prize (an additional one-million gain.) The phenomenon of decremented marginal value also occurs in losses, but to a much smaller degree. It means, among other things, that losses cause people to change their financial decisions more than do gains. Emotionally, people take profits for granted and their positive reaction is short-lived, while losses cause them great grief for a long time. This phenomenon represents risk-aversion and loss-hate, to be explained below.

 

The Bubble Effect

So when is there a high probability of real profit in entry into the stock market? Common wisdom says that it is advisable to enter the market after a period of rate drops and idleness since the actual value of companies or their growth potential is higher than their implied growth given the value of their traded stock. Pure economic sense predicts a market rise in this situation.

Defining the bubble and the right time to exit the market is more complicated. Seemingly, a bubble is created when the intrinsic value of companies is lower than the value of their traded stocks. But stock value should not only represent the value of a company at a given moment, but also the capitalization of its future market value, depending on possible growth and success that would raise its actual value (some of these expectations are economic and some psychological). Therefore, it becomes very difficult to define the bubble and the timing of its creation. The term “sentiment” describes the mood in the market, in the stock exchange and in commerce, on both the macro and micro levels. When there is a positive sentiment, stock prices are expected to rise. When it is negative, prices tend to go down. Since sentiment is undoubtedly an emotional-psychological expression, it cannot result only from rational factors. Commerce therefore depends on the emotional “caprices” of the collective mood of the masses.

Let us return now to the question of the bubble, and refer to the public and its involvement in the stock market. I claim that psychological influences cause the general public – the naïve investors who do not specialize in finance but rather “go with the flow” – to lose twice. First they lose by not gaining potential profits when the stock market rises, while they still fear entry remembering the previous crash; second, they lose when they remain in the stock market until it becomes a bubble, which bursts first and foremost in the naïve investor’s face.

Stage 1 – The public licks its wounds, “Risk Aversion": Just recently the market was unstable and still elicited negative sentiment. Some claim that the stock market preempts macro-economic events, and its rise indicates imminent economic growth; similarly, a stock crash indicates an approaching macro-economic contraction. The professional institutional investor recognizes stock investment potential based on economic analyses, such as comparing analysts’ valuations of the company to its stock price. An objective analysis of the stock value after the crash of the “new economy” would have certainly pointed to many companies with attractive trading stocks, as their intrinsic values would have been much higher than their stock market values. Yet, the naïve investor, who sought a handsome return on his investment, did not hurry back into the stock market, fearing a second crash. This situation is the opposite of the bubble. Here there are significant negative gaps between the companies’ intrinsic values and their stock market values, offering a significant profit opportunity for the sophisticated investor who has a large enough financial margin for risk-taking.

Kahneman and Tversky’s research cited above won Kahneman the Nobel Prize in Economics. The research demonstrates deviations in individuals’ decision-making processes. For example, the “risk-aversion” phenomenon shows that most people would choose an assured $500 in cash over participating in a draw for $1000 with a 50% chance to win. Financially, the possibilities are equal, but human preference tends to be conservative, preferring the guaranteed amount. Yet, when the probability of winning increases, a different tendency emerges, expressing a growing willingness to take a risk when the draw profit expectancy is greater than the guaranteed amount. Translating this theory to the state of financial markets shows that after the stock market crashed, the public perceived the market as dangerous. Since interest rates were high, it seemed preferable to invest the money conservatively (analogical to preferring the guaranteed $500). Later, the probability for profit in the stock market rose significantly, while at the same time, interest rates were lowered. This reduced the perceived risk of loss and increased the chance of profit, so the public returned to the stock market (analogical to the $1000 in a draw).

Stage 2 – Risk Aversion: There is no problem as long as the stock market tends to go up. But the naïve investor’s next decision point occurs when the trend reverses and the market starts to go down. This is where he must make a quick decision. Should he accept the losses of the last drops and exit the market until things clear up (often a sensible decision) or stay in the market in hopes it is only experiencing a corrective wave that would result in an upward trend in trading (often involving cognitive dissonance factors). Kahenman described another phenomenon, “Loss-Aversion,” that is relevant to this case. If, for example, the police catch a culprit and give him two possibilities: pay an immediate $500 fine or appeal. The appeal presents a 50% chance of completely dropping the charges, but if it is denied, the man has to pay $1000. Kahneman’s research shows that despite the apparent parallels to the previous example, people prefer to take their chances here. They are willing to take the risk in order not to be caught losing. Loss-aversion causes the investor, who had already lost part of his money as the bubble began to burst, to stay in the market and in fact lose more money. He prefers to wait and take the chance of additional losses, hoping to avoid the initial loss should the original trend resume. When reality strikes home it is usually too late; the losses are too great, and the chronicle foretold will return the naïve investor to risk-aversion. When stocks plummet, he will exit the market fearing that he will continue to lose what is left of his money, and he will wait until the stock market again generates handsome profits. As said, this would probably happen only after a significant market rise had already taken place, as has happened for everyone who just recently entered the market.

Does the naïve investor not know this chronicle foretold? In closing, I would like to cite another example from the Kahneman and Tversky school of thought. A person loses $1000 in his yard. Sad and distraught, he enters a room where he is offered two alternatives: In the first, he receives $500, indirectly compensating him for one half of the lost amount. In the second he has a 50% chance of receiving the full $1000 amount (but also a 50% chance of receiving nothing). You must remember the first example mentioned above, where risk-aversion leads the person to choose the guaranteed $500. Yet in this case, the individual prefers the gamble. He makes an irrational connection between the two independent events – the $1000 loss in the yard and the game offered in the room. Since his mood is depressed due to losing the $1000, he feels the $500 wouldn’t really compensate him emotionally. He prefers to gamble on the $1000 that may restore his self-confidence and mood following the previous loss. Obviously, he would feel despondent after losing the other $1000 in the draw as well, but he refuses to acknowledge this point of view because of cognitive dissonance processes.

The bottom line: The naïve investor faces a high risk of being drawn to serious losses in speculative financial investments, owing to lack of professional knowledge and a tendency to have psychological biases in decision-making. He faces the double risk of losing significant assets and of paying a serious personal psychological price as well. The naïve investor should therefore take several factors into account:

                                              1. Never make speculative investments with funds that are used for daily living or are reserved for pension. Risk only supplementary funds, whose loss would not risk personal or family welfare in the short and long terms.
                                              2. Take into account that the same amount of money that is expected to be won could also be lost, even if it seems completely unlikely. The investor should be psychologically convinced that he is ready to lose the same amount of money that he is hoping to win in his investment.
                                              3. Consider the individual’s psychological makeup and his ability to remain stable and “sleep well at night,” even after a significant loss of a financial investment. A person who feels his mental state would suffer from a serious loss of funds should not enter stock market investments, which may indeed yield handsome profits, but can equally cause significant loss of financial assets.