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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