How Animal Spirits affects the Stock and Property Market?

I finally know what distinguishes man from the beast : financial worries. Jules Renard, 1864-1910. French Novelist and playwright

There is one principle which a man must follow if he wishes to succeed, and that is to understand human nature. Henry Ford, 1863-1947, Founder of Ford Motor Co.

If you look at the performance of various stock markets around the world it can be best described as a roller-coaster ride. The following is the chart for our KLCI as from December 2012. Notice how volatile is the price in the chart. It is of common belief that stock prices movements are as a result of changes in economic fundamentals such as interest rates, GDP growth, consumer confidence and corporate earnings. The movement of the market index like our FBMKLCI is a result from the individual actions of thousands of buyers and sellers at the end of each trading day. Hence it can also be deduce that the movement of the individual chart movement of interest rate, GDP growth, consumer confidence or corporate earnings should mimic the movement of FBMKLCI. But what can be seen from below is that none of the individual charts movement mimics that of FBMKLCI.

Thus it can be deduced that changes in economic fundamentals does not fully explain the movement of stock prices. This is because stock prices vary too greatly. Instead the other part that causes changes in stock prices is due to human emotions. I shall present to you below a write-up on how human emotions or ‘animal spirit’ affects our decisions on investment.

By the end of this article you should learn the following.

1. What is mental accounting and prospect theory and how they affect our decision making in investing and daily lives.
2. How bubbles and crash are formed?
3. How greed and fear contributed to the wild swings in stock and real estate prices?
4. Why stock prices tend to revert to the mean?
5. How to capitalize on human emotions?

What is Behavioral Economics? Unfortunately it is one of the newer fields in the study of economics that has been literally left in the freezer. It has been taught in colleges and universities for more than 40 years but has not attracted much public attention. Behavioral Economics or sometimes called Behavioral Finance is the multi-disciplinary study of psychology and economics. Or put it simply, it is the study on how our rational and irrational decision making influences the way we invest, spend, borrow or save money. In other words it is a study of how our inborn animal instinct affects our financial decisions. Thus, by understanding how our animal instinct affecting our decision process, it tends to help us avoid many of our irrational decision making such as the following.

1. Why people tend to buy at the highest and sell at the lowest in stock market and real estate investments?
2. Why people are more willing to charge a $1000 dinner on credit card than spending $500 cash on a dinner.
3. Why we tend to spend all the money given to us by way of gift, inheritance, a profit from the stock market or a win in the lottery?
4. Why are financial prices so volatile?
5. Why are we unwilling to spend $1000 to overhaul the old car given to us by a relative?

It is also unfortunate that a lot of people believed that the economic events such as a rise or fall in the GDP, inflation rate, stock and real estate market are due to technical factors or past government decisions affecting the economy through its macro and micro-economic policies.

According to traditional economics theory that goes back to the days of Adam Smith where free market performs the best if it is left on its own, without intervention from the government. In a free market people will rationally use all available opportunities to produce goods and trade with each other. This will thus result in full employment because workers are willing to work for less than what they can demand for. Hence by this definition it also means that the economy will always achieve stability because people looking for a job will always be employed because they are willing to sacrifice for a lower wage.

However it is insufficient to solve modern day economic crisis like during the Great Depression where the height of the crisis the unemployment rate reached a high of 25%. It may helped solved the problem on why the balance 75% of the population is employed because they are willing to work for less than they can demand for. Similarly, it cannot explain why unemployment is high in the current Global Economic Crisis. The following info-graph from the World Economic Forum shows the youth unemployment throughout the world.

How Animal Spirits influence our decisions?

Hence it can be deduced that although free market capitalism may help to explain why people are employed but it may not be able to provide answers on why economies go into expansion and contraction. This is because other than making rational economic decisions people are also influenced by non-economic decision which is guided by their ‘animal spirits’. This non-economic decision is influenced by changes in our thinking process such as confidence, envy, temptation, compulsiveness, fear, greed, peer pressure, addictions and illusions. Understanding how these psychological traits in influencing how people make decisions will enable us to find answers to the earlier questions above. The fact is that now more people are making decisions that are not rational, self-interest or consistent in order to get more return from their limited resource allocation such as money.

An example is well illustrated by our recent rise of 20 cents in the RON 95 petrol. People may think that they are acting rationally by queuing up in petrol stations to fill up their tanks. They reckoned that by filling up their tanks at the old price which saves some money and hence a rational thing to do. However they failed to realized that not only what they saved is pittance but also a waste of time queuing. The savings resulted from filling up their tanks are much lesser (less than $10) after deducting the fuel spent on waiting and travelling from their home to the gas stations. Before we delve further into the field of Behavioral Finance I reckon it is best to explore how and where it began.

The origin of Behavioral Economics

Although there are many claimed they are the pioneers of Behavioral Economics but the most likely location for the beginning is at the Hebrew University in Jerusalem. In the late 1960s, two Israeli psychologists Amos Tversky and Daniel Kahneman are devising a method to motivate fighter pilots in training. The flight instructors who are taking a class in Hebrew University taught by the above psychologists found that when a pilot is praised for a good flight he tended to do worse on his next flight and similarly when a pilot is criticized for a bad flight he tend to perform better in his next flight. This led them to argue against the conventional wisdom that rewards is a better tool than punishment in motivating fighter pilots. How can this be?

One explanation offered by the psychologists is through the mathematical concept called ‘Statistical Regression’ or ‘Reverting to the Mean’. It can be best described with the following chart.

From the chart above you can see that the samples which are represented by the ‘O’ scattered around the Mean or Moving Average (Regression Line). As shown over time the ‘O’ will tend to revert back to the Mean which is represented by the Regression Line.

Similarly any flight performed by the pilot whether good or bad which can be represented by the ‘O’ in this case. Over time it tend to revert back to the mean which is also the pilot’s long rang average. Not understanding this, the instructors concluded that criticisms tend to improve the pilots performance and praise tend to degrade the pilots performance. Even in the sport of tennis, it is found that when a player had a bad forehand it will be followed by a better forehand and vice versa. The more he hit the closer will be his performance reverting to his average.

How Behavioral Economics affects our decision making?

The two pillars upon which Behavioral Economics are based on are the concept of Mental Accounting and the Prospect Theory. We shall begin with the concept on Mental Accounting first. What is Mental Accounting?

Mental Accounting

Mental accounting refers to a situation where we treat money differently depending on where it came from. To illustrate this concept we shall see how mental accounting affects a gambler. A gambler tends to gamble more when using casino chips than with cash. This is because less pain is inflicted on him as a result of his loss using casino chips than it does with cash. This is because he tends to place different value on the chips than cash.

Another example will be the different value people placed on earned income and gift income. We tend to spend the $50 given by our parents with less thought than the $50 that we earned from our job. This can help explain why people treat our Government’s BR1M as gift money and hence they will spend it without any thought. Similarly when those Felda smallholders received windfall payments from the listing of Felda Global Ventures spent their money as gift money. As a result many of them spend it on cars, motorbikes, houses and other non-income recurring investments instead of replanting their rubber trees which will provide sustainable future incomes.

Probably the best example to illustrate how mental accounting caused havoc in our personal finance is the use of credit card. If you happen to visit an electrical shop and wanted to buy an oven that cost $200. Even if you have $400 in your pocket you will hesitate to pay by cash because it will instantly reduce your cash holding and hence buying power by half. Instead you don’t have problem charging it to your credit card because you tend to treat the money differently. By charging it to the credit card you not only don’t feel any loss of buying power but also the money spent seem cheapened or devalued because we don’t feel we are spending our dollars.

Prospect Theory

The Prospect Theory deals with the way we arrive at a decision based on gains and losses of money and how it affects our attitude toward risk. Instead of assigning different value to money as in mental accounting we now assign different value to the loss and gain of money. Thus by understanding how people view losses and gains differently, it can help us figure out why people make bad decisions on investing and spending. The prospect theory can be divided into two concepts which are also known as the ‘loss aversion and sunk cost fallacy.’
Loss aversion refers to our feelings towards a loss. To illustrate the concept of loss aversion and how it affects our decision on investing we present you the following test done by Tversky and Kahneman.

Scenario 1.
You are given $1000 and asked to choose between two options. Option 1 is you are guaranteed $500 and option 2 you are to flip a coin. If it’s head then you will receive an additional $1000 and if it’s tail then you will get nothing more.

Scenario 2.
Again you are given $2000 and asked to choose between two options. Option 1 you are guaranteed to lose $500 and option 2 you are to flip a coin. If it’s head you will lose $1000 and if it’s tail then you will lose nothing.

Which option will you choose in Scenario 1 and 2? The result suggests that most people will choose Option 1 in Scenario 1 and Option 2 in Scenario 2. This is because when you choose the above it shows that you are only willing to take more risk when losses are avoided hence ‘loss aversion’.

How does loss aversion affect us in Investing?

Understanding the concept of loss aversion can be very useful in helping us to improve our decision in investing. For those who are very sensitive to losses it implants a loss-phobia in them. During market downturns they are the ones who will panic sell and tend to get out of the market too soon. Watching their stocks going down with the market is something that is too much to bear and hence what other way than selling to stop the pain. However by reacting too spontaneously, the investor might not be able to differentiate whether the market reaction is a profit taking or crash. If the market reaction is due to profit taking then the investor have made a wrong decision. Additionally he will be subjected to another round of pain by watching his stocks rising again.

Another effect of loss aversion is making us holding on to our bad investments for far too long. I am sure during your investing career you had come upon stocks that are underperforming or so-called dogs. Due to your attitude towards loss aversion you tend to hold on to them forever believing it will make a comeback one day. The problem is that most of the time it doesn’t.

So what we can deduce from the above is that investors tend to sell winners too quickly and kept losers too long. This is because according to the loss aversion concept, it is less painful to sell winners and keep losses. This led them to do the opposite the sound investment strategy of ‘letting your profits run and cutting your losses’. This situation is also known as the ‘disposition effect’ in economics.

Sunk Cost Fallacy

Sunk cost is a cost that has already been incurred and cannot be recovered like paying the deposit for a home or car. An example to illustrate how sunk cost affects our decision making is the research paper by Hal. R. Arkes and Cathering Blumer of Ohio University titled ‘The Psychology of Sunk Cost’ in 1985.

In this experiment three groups of people are paying different prices for their theatre