Sunday, October 19, 2008

On Wall Street: Overcoming the herd instinct - FT

By Aline van Duyn Published: October 17 2008 17:18 Last updated: October 17 2008 17:18 Adam Smith’s “invisible hand” has been replaced in the world financial system by a very visible government fist. The theory by the famous 18th century economist was originally part of a discussion about domestic versus foreign trade. It has since been applied to markets more generally. It suggests that, in a free market, an individual pursuing his own self-interest will make choices which will also tend to benefit the entire community. However, Mr Smith wrote not just about economics, but also about psychology, although that is not what it was called at the time. His observations about the way people react to good and bad experiences are useful at this time, when most investors – from professionals to individuals saving for their pensions – have lost money. Specifically, Mr Smith wrote that ”we suffer more... when we fall from a better to a worse situation, than we ever enjoy when we rise from a worse to a better.” The pain felt now is, on that basis, very acute indeed. Take US equity markets, down over 20 per cent in the last month. Brazilian shares are down nearly double that. Corporate bonds have done little better. In September, junk bonds not only notched up their worst performance in one month, but it was worse than any loss for a full year. Amplify those numbers by the mental anguish of losing, and it is no wonder than people are running for the exits. It is the psychology of the markets that now has to be addressed, and policymakers could do worse than remember some of the key issues which affect people’s decision making at times like these. In a downturn, the gloom and doom can be hard to break. Much has been written about how much decisions depend on the context in which they are made, but here are a few useful examples. Recent events can shape expectations. If your recent experiences are harsh, you are likely to be more cautious. Another factor, called “anchoring”, is also interesting. Take the study by Ariely, Loewenstein and Prelec in 2003. Business students were asked if they would buy products like bottles of wine for a price equal to the last two digits of their social security numbers. Though entirely random, if this number was higher, they were willing to pay more, than if the original random number was lower. To be specific, people with numbers in the bottom half of the distribution priced a bottle of wine - a 1998 Cotes du Rhone Jaboulet Parallel ‘45’ – at $11.62, while those with numbers in the top half priced the same bottle at $19.95. There is clearly something appealing about an expensive good, and this appeal seems to extend to investments. Financial advisors, as well as our financial leaders, need to don their psychologist hats and help people understand their irrationality. “It is just what humans do, they run with the crowd,” said Gregg Fisher of Gerstein Fisher, an investment advisory firm in New York. Mr Fisher said he has had calls from young clients who have wanted to stop monthly payments towards their retirement savings. “This makes absolutely no sense, it is better for them if they can buy stocks more cheaply. But it feels better to buy when something is expensive.” As heads of state, policymakers, central bankers and numerous others try to inject confidence to the markets, they could do worse than step back, and recognise the pain people feel. Mr Fisher sees his role as “helping people recognize the reality of how the human brain works, so that they can catch themselves.” Warren Buffet on Friday reiterated one of his long-held views in an opinion piece which was published in the New York Times: ”A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful.” It is easier said than done, but perhaps it needs to be said a lot more often. Aline van Duyn is the FT’s US markets editor,

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