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Irrational Exuberance

Herd Behaviour And Epidemics

It is a known fact about human society that people who communicate regularly with each other, think similarly. The reason that people's judgements are similar at times is because they are reacting to the same information.

 

SOCIAL INFLUENCE AND INFORMATION

Renowned social psychologist Solomon Asch's findings were widely cited in the media for providing a scientific basis for claims that people do not have fully independent judgement. "The Asch conformity experiment" revealed the degree to which a person's own opinions are influenced by those of others. He found that people were willing to ignore reality and give an incorrect answer in order to conform to the rest of the group. People experienced anxiety and distress and thought that their own senses were somehow not reliable. Results of Stanley Milgram can also be considered here. Thus, many people are accepting of the perceived authority of others related to stock market valuation.

 

ECONOMIC THEORIES OF HERD BEHAVIOUR AND INFORMATION CASCADES

Herd behaviour, although individually rational, produces group behaviour that is irrational. This herd-like behaviour is assumed to arise from an information cascade. The popular notion that the level of market prices is the outcome of a sort of vote by all the investors about the true value of the market is wrong. Rather people are rationally choosing not to exert any individual impact on the market. In the end, all such information cascade theories are theories of failure of information about true fundamental value to be propagated and evaluated.

 

HUMAN INFORMATION PROCESSING AND WORD OF MOUTH

A vital component of information processing ability is effective communication of important facts from one person to another. Evolutionary changes within the human brain have created an emotional drive to communicate effectively. In modern society, a rapidly spreading conversation about a buying opportunity or news related to the stock market is more likely to happen. Transmission of such knowledge is effortful, infrequent and imperfect.

 

FACE TO FACE COMMUNICATIONS VERSUS MEDIA COMMUNICATIONS

The ability of conventional media to generate active behaviour is still limited. Interpersonal and interactive communications have the most powerful impact on our behaviour. The work of the market surveillance units at the exchanges and within the Securities and Exchange Commission (SEC) have amply illustrated the power of interpersonal, word of mouth communication. This form of transmission of information can proceed with great speed and across various social groups. It is an important contributor to day-to-day or hour-to-hour stock market fluctuations. The written or electronic sources do not carry any emotional weight and thus it is difficult to remember information from them. The telephone is the most important artificial medium for interpersonal communication today. The proliferation of telephones made it easier to sell stocks to the public. Continued technological progress in communications media that allow better stimulation of face-to-face communication will make the transmission of ideas more effective in the future.

 

EPIDEMIC MODELS APPLIED TO WORD-OF-MOUTH COMMUNICATION

Economist "Alan Kirman" discovered that the epidemic models also seemed related to stock market price changes. Epidemic models have been used by sociologists to predict the course of word-of-mouth transmission of ideas. The accuracy of transmission however, falters as the chain continues. An important national news unrelated to financial markets may lower the infection rate of ideas related to speculative markets by deflecting attention from them.

 

Conversely, national news that ties in with or encourages discussion of the stock market may raise infection rates. Word of mouth may function to amplify public reaction to news events. Thus, the likelihood of any event affecting market prices is enhanced if there is a good and vivid story about the event. By analogy, news events are more likely to contribute to the contagion of ideas. Word of mouth communication, either positive or negative, is an essential part of the prison of speculative bubbles.

 

A POOL OF CONFLICTING IDEAS COEXISTING IN THE HUMAN MIND

A reason why the transmission of ideas can happen so rapidly is that the ideas in question are already in our minds. Even conflicting ideas can coexist in our minds at the same time. People sometimes think that they have heard both views being endorsed by experts and so they are able to hold these conflicting views simultaneously. People do not worry about the apparent contradictions because they believe that the experts have already thought everything through. People have no clear attachment to many of their views.

 

SOCIALLY BASED VARIATIONS IN ATTENTION

The human brain is structured to have a single focus of conscious attention at any given time and to move rapidly from one focus to another. The ability to focus our attention on things that are important is one of the defining characteristics of intelligence. One of the mechanisms to direct attention properly is 'socially based selectivity'. We pay heed to a lot of the same things that others around us are paying attention to. This concept of social attention is one of the greatest creations of behavioural evolution. Thus, markets on opposite sides of the globe move together.

 

PEOPLE CANNOT EXPLAIN CHANGES IN THEIR ATTENTION

People often find it difficult to explain what made them decide to take a particular course of action; the original attention trigger may not be remembered. This is a major reason why changes in speculative asset prices often seem inexplicable. Most of the investors in rapid-price-increase stocks themselves say that they are unsystematic in their decision-making. By analogy, a stock market boom can start for no better reason than these irrational actions.

 

THE STORY SO FAR

This chapter concludes that irrational exuberance is at work in producing the elevated stock market levels.

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