Market Overview
When investors freak out
The price of gold jumped from $650 in 2007 to $1,900 in 2011. Then, on one September day, the price for this inflation hedge dipped 6%. It then kept dropping as panicky investors tried to dump it as fast as they could. There was no real reason to fret, though. It hit a support level around $1,100 and now trades back in that $1,900 range.
So why the irrational behavior? Is it just that “gold bugs,” as New York University economist Nouriel Roubini calls them, are “a combination of paranoid investors and others with a fear-based political agenda [who] were happily predicting gold prices going to $2,000, $3,000, and even to $5,000”?
While that’s partially true, that would only explain why it happened in the precious metals space. But it has happened in everything from real estate to stocks to mortgage default swaps to tulips.
“Despite standard investment advice to the contrary, individuals often engage in panic selling, liquidating significant portions of their risky assets in response to large losses,” according to findings from a team at the Massachusetts Institute of Technology. “We find that a disproportionate number of households make panic sales when there are sharp market downturns, a phenomenon we call ‘freaking out’.”
Trigger warnings
Freaking out, by definition, suggests that the perceived problem in the market is not as bad as the out-freaker thinks. Still, freaking out itself is a major problem and leads to significant dissolution of a household’s wealth.
The MIT team defines freaking out as a decline of at least 90% of a household account’s equity assets in less than a month, of which 50% or more is due to trades.
There’s also evidence to suggest – our assertion, not MIT’s – that freaking out follows the same pattern as the Dunning-Kruger effect, which demonstrates how low-skilled people overestimate their skill while high-skilled people underestimate their own.
"[T]he miscalibration of the incompetent stems from an error about the self, whereas the miscalibration of the highly competent stems from an error about others," according to David Dunning and Justin Kruger, the psychologists who identified the phenomenon in 1999.
But back to freaking out.
“Investors who … self-identify as having excellent investment experience or knowledge tend to freak out with greater frequency,” according to the MIT paper.
It doesn’t take much to trigger the response. It could be rooted in the assumption that the price of an asset that’s going up now will continue to trend up. It happens in real estate all the time. At the lowest point of the 2008 financial crisis, there were 11,000 homes in foreclosure in Cape Coral, Fla. You could’ve bought with a credit card. The same thing happened in Dubai, United Arab Emirates, just a few months later for pretty much the same reason. It looks like it’s happening in China now.
This is what happens when speculation gets too far ahead and economic instability sets in. With economic instability often comes political instability, and that can also lead to panic.
Misbehavior
This all falls under the aegis of behavioral economics, the study of how emotional and cognitive factors effect financial decisions. Behavioral economics sits at the corner of the rational, data-driven world of finance and the messy, confused world of the human beings to whom the implementation falls.
Oddly enough, the scientific study of behavioral economics is older than that of economics itself. They both go back to Scottish academic Adam Smith, whose The Wealth of Nations is considered the cornerstone of all subsequent economic thought. He published that treatise in 1776, but his similarly groundbreaking essay, The Theory of Moral Sentiments, went to press in 1759.
“The thought of their own safety, the thought that they themselves are not really the sufferers, continually intrudes itself upon [people]; and though it does not hinder them from conceiving a passion somewhat analogous to what is felt by the sufferer, hinders them from conceiving any thing that approaches to the same degree of violence,” Smith wrote.
Sadly, not all Enlightenment writers had the same knack of getting to the point as did Thomas Paine, but the gist is this: While individuals might truly have empathy for someone else, they’ll take care of their own needs first. And if, in their own minds, that means dumping their shares before you get a chance to dump yours, then that’s what they’ll do regardless of whether or not it makes objective sense.
While we can’t recommend Smith’s collective works to you, we’re fortunate to have a contemporary economist who makes the case more clearly. Nobel laureate Richard Thaler (pronounced “taller”) was among the founders of the modern field of behavioral economics. In the late 1970s, Thaler and his colleagues first identified the endowment effect, which suggests that people prefer to value an object they own in excess of what they’d have to pay to acquire it. This led to many other academic rabbit holes:
- People seek a quick, satisfactory solution rather than invest time and mental energy in finding an optimal one.
- People are more eager to avoid a loss than to realize a gain of the same value.
- Positive reinforcement works better as a behavior influencer than education, legislation or enforcement.
And many more. We won’t go into them here, but we recommend Thaler’s general readership, semi-autobiographical Misbehaving: The Making of Behavioral Economics.
Seeking out
Have you ever freaked out? Would you ever? Are you the best judge of how to answer these questions?
This is where having a trusted financial advisor comes in handy. We all have biases. We all have blind spots. Sometimes it helps just to have a dispassionate person take an objective look at your financial decisions.
The hardest thing investors need to figure out, it seems, is their own selves.
