Snippets From The World Of Psychology - September 2008
Given the turmoil in the local and global financial markets over the last twelve months, it seems appropriate to look at the role of psychology as it applies to individual economic and market behaviour.
Daniel Kahneman – Psychologist and Co-winner of the 2002 Nobel Prize for Economics
One of the best presentations I have had the privilege of witnessing was conducted by Daniel Kahneman at the 4th Industrial and Organisational Psychology Conference in Sydney in 2001. An erudite speaker, Professor Kahneman’s work on behavioural finance/economics challenges the traditional beliefs that rational agents are unbiased in their assessments of chances of success and failure and are insensitive to details of framing and formulation. Daniel Kahneman’s work (and that of others) finds that ‘real’ agents often possess the following characteristics:Professor Kahneman provided a number of illustrations in his presentation. For example, in discussing the exaggeration of skills, he noted that when people are asked to rate their level of driving skill, between 80% and 90% rate themselves above the median. A similar statistic occurs when people are asked to rate their sense of humour.
The effects of loss aversion (which can be described as ‘irrational’ decision-making) means that individuals perceive a potential loss as having about two and a half times the impact of a gain of the same magnitude. Accordingly, investors quite often hang on to a failing asset. This can be associated with the sunk cost fallacy as mentioned in the July 2008 snippet, “Why pay more?” Interestingly, Daniel Kahneman indicated that women are better investors as they are ‘less over confident’ and have fewer bad ideas. (However, see the work of Sornette below – the networking phenomenon may negate this gender imbalance?)
Economic Decision-making – Rational or Irrational?
One of the key hallmarks of the standard economic approach involves the unquestioned assumption that people and companies are rational, selfish, independent economic agents. The efficient market hypothesis is also part of this traditional approach in that it basically states that shares, for example, will be traded at their correct value as all information has been made publicly available and has been factored in to the price of the asset. However, Didier Sornette (author of books such as Why Stock Markets Crash: critical events in complex financial systems) has undertaken work investigating the effect of herding behaviour on the rallies and crashes that appear to be part of the financial markets. His models have shown that news from the real world does have an effect on markets. However, whilst public and private information tends to keep prices around realistic values (consistent with the classical equilibrium model), Sornette and his colleagues have found that social networks (spread by word of mouth and internet chat) can lead to bubbles – assets that become priced too high or too low. These bubbles can be triggered by nothing more than a random streak of news which then becomes amplified by social feedback. This phenomenon, which should be considered a positive feedback loop, is often part and parcel of poor decision-making and part of phenomena that can be labeled ‘groupthink’.
This would seem to suggest that increasing use of social and professional networks (such as Facebook and LinkedIn) does not augur well for our financial markets!
Final Comment
Psychology and economics do overlap as both are concerned with human behaviour. Economics draws much more on mathematical models and key concepts such as the Marshallian (supply/demand) cross. Psychology is very diverse but draws more on laboratory studies and field experiments. More recently, neuroscience and cognitive psychology have emphasised the importance of emotion and brain mechanisms in decision-making. Even social psychologists are joining in, with Professor Stephen Worchel, of the University of Hawaii, seeing similarities between the development of an economic recession and ethnic violence. The common themes: fear and anxiety. Furthermore, I recall the then President of the International Association of Applied Psychology (Professor Michael Frese of Germany) noting, at the 26th Congress in Athens (2006), that economists were becoming significant professional competitors to organisational and applied psychologists.
The above is interesting given that, in the wisdom of Canberra bureaucrats and politicians, psychology in Australia is moving to a situation where the regulation of the profession will be subordinate to a health model. A new national scheme, which is due to commence in July 2010, will cover nine health professions which currently are subject to statutory state-based registration. The entire profession of psychology will be subject to the health workforce reforms. Similar regulations are being enacted in New Zealand, Great Britain and the USA. We only hope that (non-clinical) applied psychologists are not swamped in the health industry cavalcade – it is just amazing that industrial/organisational/work psychologists are caught up in these streamlining reforms.