Panic, Contagion and Mass Market Movements

Sixteen years ago I wrote down the above title on my “Work in Process” list, thought about it for a few minutes, and put it at the bottom priority. Granted, it was a complex and poorly understood topic for which I intended to offer a new  formulation – but it was hardly a burning issue. To find familiar examples I would have had to reach back to the Great Depression of the 1930’s, or the post-war hyper-inflationary periods in Germany and Hungary – historical curiosities that had no perceivable relevance to our world in 1996. Common wisdom and expert opinion agreed: We were beyond all that.

But here we are in 2012 and all that has changed. We have seen the unthinkable occur, again and again: a major investment bank going bankrupt, housing prices plunging across the board and staying down, a global near financial meltdown, people actually paying serious attention to Nassim Taleb – and now we face the  imminent possibility of default on sovereign debt by major European nations, and perhaps even the collapse of the Euro.

The topic now seems, if anything, too timely. Every second article in the financial press seems to be about when the next break in the global economy will come, how far it will spread and how rapidly. Rest assured, this is not yet another Chicken Little post. The economic sky may in fact fall, but that’s for others to predict.

What I’m interested in here is: What actually happens with individual investors that results in panic, contagion and mass market movements, and how can we spot it before it comes crashing down around us?

A New Year’s Gift: Practical Implications, Round 1

Behavioral economists come up with catchy labels for research findings, like “loss aversion” and the “endowment effect”, but as we have seen these labels don’t actually explain anything because they are not part of a conceptual framework within which they make sense. As a result, they give us no practical guidance in deciding what to do about these “irrational” tendencies. This post will use our alternative formulations to provide just such guidance.

What are we to do about the fact that people value what they have over the same thing belonging to someone else? About the fact that buyers of stock are overly reluctant to sell it at a loss, and that champions of projects continue to fund them when clear-eyed analysis says that pulling the plug is the better course? We begin by recognizing, as previous posts demonstrate, that such behavior is not “irrational”; in fact, in light of the person’s circumstances, the behavior makes sense. Once we see the sense it makes, we’re in a position to do something sensible about it.

What’s Really Going on With “Sunk Cost”

“Sunk cost” is tricky stuff.

It is a standard accounting term, referring to the investment already made in an asset or project. When deciding how to value the asset currently, or whether to invest further in the project, we are firmly admonished to ignore “sunk cost”, and to make our evaluations based on its current market value (or expected future value). This is sound advice, rational to the core, and is perfectly in accord with classic economic theory.

So what’s the rub? To the consternation of accountants, economists and financial advisors everywhere, when we look at actual investment decisions, people routinely do NOT ignore sunk costs. What they have already invested is typically a factor – sometimes a determining factor – in what they decide to invest now. Talk about “irrational”! And since behavioral economists do talk about “irrational” they account for this and many other common deviations from rational practice by invoking the “Endowment Effect.”

In the first post of this series, “Take the Cash and Let the Credit Go”, we saw how “loss aversion” is an ad-hoc account of research data that merely labels the phenomenon but in no way explains it, and gave an alternative formulation that actually predicts the research findings. In this post we will subject the “Endowment Effect” to the same treatment, with an interesting twist: exactly the same conceptual structure that predicts loss aversion also predicts the Endowment Effect! This is our first solid clue that we are on to something really different and powerful here. (And there’s a good deal more where these come from, as we shall see as this series unfolds.)

Take the Cash and Let the Credit Go

Behavioral science research reminds me of the fabled Rocky Mountain oil shale deposits: Both are reservoirs of tremendous potential value, locked up in a framework that makes tapping that potential next to impossible.

Solving the oil shale problem seems to require better and stronger technology; solving the behavioral science research problem requires better and stronger conceptualization. Fortunately, that conceptualization is available and well-developed, in the powerful conceptual net called Descriptive Psychology. What is called for now is a thorough reconsideration of behavioral science research, to create a fresh understanding of what has been discovered that unlocks the value in the findings.

Let me be clear: since at least the 1970’s an enormous body of sound empirical research has been accomplished in behavioral science, including, among many other domains, behavioral economics, social psychology, cognitive psychology and neuroscience. I take these findings as given. It is not my intention to question the findings; rather I intend to question the explanations researchers have given of their findings, and to offer other, more plausible and considerably more powerful explanations in their place.

As Omar Khayyam said in a different context, I intend to “Take the cash, and let the credit go.”

Here’s a specific example: