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The newspaper of The Johns Hopkins University December 1, 2008 | Vol. 38 No. 13
Anxiety, Fear and the Stock Market

A psychologist and attorney, Lawrence Raifman teaches an undergraduate course called The Psychology of Decision Making: Behavioral Finance.
Photo by Will Kirk / HIPS

A psychologist gives students insight into today's economic crisis

By Lisa De Nike

According to Lawrence Raifman, market valuations are like Goldilocks' porridge: They're either too hot or too cold and seldom "just right."

A psychologist and attorney who teaches in the Krieger School's Department of Psychological and Brain Sciences, Raifman uses a psychological lens to help undergraduates understand the stock market and all its recent fluctuations through a course titled The Psychology of Decision Making: Behavioral Finance.

On a recent afternoon, Raifman, an adjunct assistant professor who currently is studying to earn a certified financial adviser credential, sat down with The Gazette to offer his insights into how psychological principles underlie what's happening in the market now and what — if anything — can be done to remedy what's wrong.

Q: It's been said that fear and anxiety are playing a role in keeping the market in crisis. In other words, as investors and traders see the market drop, they become fearful of investing, causing the indexes to continue to plummet. Is this true?

A: Yes, anxiety and fear are significant factors. It is hard for people to avoid overreacting to the current crisis affecting the stock market. In the past, we have had periodic downturns in the market which were just a routine part of the economic cycle; that is, economic conditions have always moved up and down. Markets generally overreact on the upside in good times and on the downside in bad times because people rely upon simple rules of thumb known as heuristics when making decisions. [Editor's note: Heuristics are mental shortcuts not necessarily based on facts, base rates or probabilities that can be essential when making optimal decisions.]

This often leads to people making decisions which, for example, overemphasize the present and neglect to take into consideration a long-term perspective. This leads investors to treat stocks like they are voting in a popularity contest. But in the end, markets are often psychologically driven by fear and greed more than they are by rational or optimal decisions. Frequently, only in hindsight are people able to recognize the onset of a crisis such as the one we are weathering now. People fail to adjust their appetites for risk until it is too late, and they then get swept up in flight to safety, either by abruptly selling their stock or failing to buy, which inadvertently contributes to the problem.

Q: Can you explain to us what behavioral principles are at work in the current crisis?

A: Research has proven that losses are more painful than gains are pleasurable. So, faced with the expectation of losses in the stock market, people at first will choose to take large risks to avoid losses, given that losses are so repugnant to them. In financial markets, this leads to the pattern where investors ignore developing bad economic conditions for a period of time, or choose to avoid knowing what is in their monthly statement, and then experience significant fast-paced, large downturns, as has occurred in the financial markets in October 2008. At first, it is hard to sell "losers" assets which have gone down in price. After a period of pain and forced selling in which the market will eventually capitulate, opportunities arise, and money starts going back into the marketplace.

In addition, financial market research has shown that there are times when investors behave unexpectedly, creating puzzles for market analysts. We don't understand, for instance, why the financial markets seem to experience gains in the autumn and losses in the summer. Other so-called market anomalies include biases such as something called "the January effect," in which stocks tend to rise in price between the last day of December and the fifth trading day of January, and the home bias, which is the tendency for investors to invest in a large amount of domestic equities despite the purported benefits of diversifying into foreign equities. Outside of the marketplace, researchers have studied why so many workers fail to save for their retirement, noting that such behavior does not fit with expectations defined by the life cycle hypothesis. In other words, people know that they are going to need the money [for retirement], yet they don't save for it because they overweight their desires for what they want to buy now rather than saving for the future.

Q: What should the average person know about why this is happening?

A: Investors and consumers should appreciate that complicated processes influence their buy and sell decisions. Decision makers are affected by neurologically based brain behavior that has an impact on their economic decisions. Basically, there is a kind of "turf battle" between different parts of the brain over how economic decisions are made. From stock market to consumer shopping decisions, people are conflicted as to whether to buy or postpone purchases and save for the future. For example, when offered the chance to buy chocolate today for a slightly higher price or wait and buy it at a lower price, most consumers will choose to buy today, even though that doesn't make financial and economic sense.

This tendency has created an opportunity for advertisers to exploit the internal brain conflict in favor of immediate purchases, with the result of putting people into debt. Thus, when consumers, hungry to own their first home, were given the opportunity to buy a home at an attractive initial rate that becomes burdensome over time — for instance, at a subprime rate — rather than postpone that decision or obtain a more appropriate interest rate, their brain physiology may well have worked against them.

However, while investor/consumer mentality does aggravate and exaggerate market anomalies, to blame the market downturns completely on investor psychology would be too simple. It's far more complicated than that.

Q: Is there anything else we need to know?

A: Given the puzzles created by investors' less than fully rational stock market behavior, behavioral finance researchers focus on how an investor approaches and makes finance decisions, rather than uncovering what might be an optimal investment decision. By tracking and describing investor actual decision-making behavior, this interdisciplinary study of finance has as its goal the cataloging of the psychological and neuro-economic mediated rules of investment behavior. This current period of market turbulence and stress offers clear evidence of the importance of behavioral finance investigation. We definitely need to learn more.


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