See­ing clearly through the red

Avoid herd men­tal­ity, urges be­haviourist

Calgary Herald - - Calgarybus­iness - THERESA TEDESCO CANWESTNEW­S SER­VICE

In the es­o­ter­ic­world of be­havioural eco­nomics, Mon­day’s stock mar­ket sell-off sig­nalled that in­vestors are firmly in the “red” zone.

Ac­cord­ing to the colour-coded spec­trum of panic em­ployed by the ex­perts, it means the herd men­tal­ity has seized con­trol of our col­lec­tive senses, and the bal­ance of de­ci­sion-mak­ing is tipped over­whelm­ingly in favour of emo­tion rather than sober rea­son­ing.

Tra­di­tion­ally, neg­a­tive move­ments, whether they are on a com­pany’s bal­ance sheet or on a trader’s screen, are al­ways coded in red. Pos­i­tive move­ments, which have been in short sup­ply of late, are coded in green.

What in­vestors around the world­were re­spond­ing toMon­day­was their per­cep­tion of red.

“Peo­ple are ter­ri­fied,” said Lisa Kramer, as­so­ciate pro­fes­sor of fi­nance at Rot­man School of Man­age­ment at theUniver­sity of Toronto. “I see a lot of peo­ple re­act­ing emo­tion­ally to the mar­kets. Cer­tainly there are things go­ing on eco­nom­i­cally that are wor­ri­some, but do they jus­tify the kinds of move­ments that we’ve seen? I don’t think so; not at a fun­da­men­tal level.”

OnMon­day, amid hardly stun­ning pre­dic­tions that Canada may be headed into re­ces­sion along with the rest of the­world’s ma­jor economies, theTSX plunged 1,100 points in a mid­morn­ing anx­i­ety-stricken sell-off, be­fore it plateaued to end the day with a four per cent loss.

That be­hav­iour mir­rored sim­i­lar alarm in theUnited States. All this on the first trad­ing day af­ter theU.S. gov­ern­ment signed off on a $700-bil­lion US res­cue plan.

For­weeks, there has been a per­fect storm gath­er­ing: less than op­ti­mistic eco­nomic news on the hori­zon, po­lit­i­cal un­cer­tainty with ma­jor elec­tions in­North Amer­ica, a credit squeeze amid un­prece­dented lev­els of debt, and a mas­sive gov­ern­ment bailout that­worked itsway throughU.S. Congress.

Add to that the “cas­cad­ing” ef­fect, for ex­am­ple, when com­men­ta­tors such as self-de­scribed fi­nan­cial guru JimCramer bel­lows out in a “dra­matic state­ment” that in­vestors should yank their money out of the stock­mar­ket if they need it within the next five years. Cramer’s dire procla­ma­tion that stocks could lose 20 per cent of their value is di­rected at view­er­swho may be among the ca­su­al­ties of theU.S. mort­gage cri­sis, which is akin to pour­ing gaso­line over a rag­ing in­ferno.

In be­haviourist lingo, this is called “aw­fuliz­ing,” which means in­vestors are grav­i­tat­ing to­ward the­worst pos­si­ble out­come by mak­ing short-term de­ci­sions that of­ten have a self-proph­e­siz­ing ef­fect. Con­sid­erMon­day’s nose dive af­ter the re­ces­sion pre­dic­tions.

“When peo­ple get anx­ious about their fi­nances, we don’t nec­es­sar­i­ly­make the most sen­si­ble choices un­der th­ese cir­cum­stances,” ex­plains Prof. Kramer.

And even though the his­tory of stock mar­kets is lit­tered with booms and busts, hu­man be­hav­iour en­sures that the herd­men­tal­ity in­evitably dom­i­nates.

Af­ter all, when a bunch of peo­ple are sell­ing their stock, who wants to buck the trend and risk be­ing the last per­son hold­ing worth­less pa­per?

If there is money to be­made, most peo­ple­want to be part of that joyride. Con­versely, if there is money to be lost, no onewants to be around for that un­pleas­ant ex­pe­ri­ence.

For now, be­havioural eco­nomics can ex­plain­why the herd in­stincts take over, but it can­not clar­i­fy­why such sen­ti­ments change the course of events. The evolv­ing sci­ence can mea­sure the wild mar­ket fluc­tu­a­tions and even at­tempt to ar­tic­u­late the fear that is fu­elling them. Yet there is no clear pre­scrip­tion for­whatwill make them stop or change course.

And though she un­der­stands more than most­what is be­hind the de­ci­sions, Prof. Kramer still re­sponds emo­tion­ally very much like her shell-shocked in­vest­ing brethren.

“My con­fi­dence is shaken,” she says, ad­mit­ting that it has been painful to re­viewthe dam­age done to her per­sonal stock port­fo­lio. Even so, she says, “Iwent again­stmy emo­tional re­ac­tion.”

Put sim­ply, the pro­fes­sor de­fied the trend to red andwent on a buy­ing spree­while the herd was go­ing the oth­er­way.

“I bought to­day. Prices are re­ally cheap right now,” she said rather sheep­ishly. “I’m looking at it in the long-term.”

Canwest News Ar­chive

Lisa Kramer, as­so­ciate pro­fes­sor of fi­nance at the Rot­man School of Man­age­ment at the Univer­sity of Toronto, says in­vestors are un­wisely re­act­ing emo­tion­ally to the stock mar­ket changes.

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