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Irrational Exuberance

Psychological Anchors For The Market

To understand the true nature of the anchors of the stock market, we must also consider the psychological factors. Investors are observed as frenzied or euphoric during booms or stock market crashes. Solid psychological research shows that there are patterns of human behaviour that suggest anchors for the market that would not be expected if the markets worked entirely rationally. These patterns are the result of the character of human intelligence reflecting the strengths as well as the limitations. Two kinds of such psychological anchors are considered here –

 

a)Quantitative anchors: These give indications for the appropriate levels of the market that people use as indicators of whether it is a good time to buy stocks or not. 

b)Moral anchors: People operate by determining the strength of the reason that compels people to buy stocks.

 

QUANTITATIVE ANCHORS FOR THE MARKET

Using quantitative anchors, people weigh numbers against prices when they decide whether stocks (or other assets) are priced accurately. Ranges on questionnaires serve as "anchors" to which people make their answers conform. People's decisions are almost always influenced by whatever anchor is available at the given moment. While making judgements about the level of stock prices, the most feasible anchor is the most recently remembered price. This enforces the similarity of stock prices. Another anchor can be the nearest breakthrough of a prominent index such as the 'Dow Jones'. This may help to explain unusual market behaviour. Past price changes may also prove to be an anchor. For individual stocks, price changes tend to be anchored to the price changes of other stocks and the price-earnings ratio is anchored to other firms' price earning levels.

 

MORAL ANCHORS FOR THE MARKET

With moral anchors, people compare the intuitive or emotional strength of the argument for investing in the market against their wealth. The market is not prevented from going up to arbitrarily high levels because people do not have an idea about what its intrinsically 'right level' is. Underlying this notion is the psychological principle, that much of the human thinking that results in action is not quantitative but instead it takes the form of storytelling and justification. Our culture may give us reasons to hold stocks and other savings vehicles that are related to our identity as responsible and level headed persons. Investing millionaires who do not test the market by trying to cash out and consume their wealth are just the type of moral anchors needed to help sustain an unusual bull market.

 

OVERCONFIDENCE AND INTUITIVE JUDGEMENT

There appears to be a prevalent human tendency toward overconfidence in one's beliefs. People think they know more than they actually do and they often act on things they know very little about. Perhaps, in evaluating the soundness of their conclusions they forget about many elements of their reasoning that could be wrong. The reason for overconfidence may also be associated with hindsight bias. Patterns of cogitation referred to as "magical thinking" or "intuitive thoughts" by psychologists also play a role. People tend to make judgements in uncertain situations by looking for familiar patterns and assuming that future patterns will resemble the past ones. This peculiarity of human judgement is called the 'representative heuristic'.

 

Overconfidence is a major factor in promoting the high volume of trade that we observe in speculative markets.

 

THE FRAGILITY OF ANCHORS: DIFFICULTY THINKING AHEAD TO CONTINGENT FUTURE DECISIONS

News events have an impact on people's reasons that even they could not have anticipated. This is responsible for the dramatic shifts of the market. According to psychologists, people cannot make a decision until the events actually occur. The effect of news stories on the stock market sometimes have more to do with 'how we feel' about the news. People discover things about their own emotions and inclinations, only after the price changes occur.

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Units 8/13