F E B R U A R Y 2 0 0 9 I S S U E
The Big Question
Opening photo by
How much of the current financial meltdown was created
by the human mind?
A: "The financial meltdown is best explained by a 'Goldilocks and the three bears' model. At first, the economy becomes too hot, then too cold, and then finally there is a movement toward righting the balance. When it is too hot, there is excessive risk taking attributed to easy credit brought on by low interest rates and complex financial instruments like collateralized debt obligations. Then, when it gets too cold, we enter into a period of excessive risk avoidance characterized by the liquidity crisis, a contraction in consumer spending, and deflation in commodities. What we're searching for now is the balance, a period when the excesses are cut out. That's the simplified economic explanation of it.
"Psychological factors exaggerate and extend these market realities, on both the upside and the downside, and can pose an obstacle to achieving that balance. Two processes of particular interest are what I call the herding mentality and cognitive sweating. Investor decisions in financial markets are not undertaken in a vacuum. When an individual chooses an investment to buy or sell, he is likely to place too much weight on public information and underrate the information he has generated on his own because there is innate comfort in following the herd. We have recently witnessed indiscriminate selling consistent with this mentality. What's more, investors' attitudes toward risk have moved in lockstep, becoming decidedly negative. The price paid for the comfort of the herd-driven investor is amplified in this environment and can result in a prolonged recoiling of the market.
"This mirrors the workings of the human mind, which is programmed to survive by taking flight in the face of danger. We see this reflected in cognitive sweating, a phenomenon in which two regions of the brain, the limbic system and frontal lobe, come into conflict. In the case of the investor, the impulse to sell — or take flight — competes with the long-term objective to maintain perspective. In financial markets, this conflict is expressed by the impulse to sell on the downturn to protect oneself, or buy on the upturn to benefit oneself. The problem for investors is that the market is too efficient to beat by impulsive trading. Investors too often act too late.
"Investors must take these two important psychological components of decision making into account. If the financial crisis teaches us anything, it is that investors have failed to factor in the influence of the human mind."
Lawrence J. Raifman is an adjunct professor of
psychological and brain
sciences at the Krieger School of Arts and Sciences and
a candidate in the Chartered Financial Analyst certificate
program at the Carey Business School.
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