With all the action on the stock market over the last few days, I thought it would be an opportune time to look at the behavioural aspects of share trading.
As Jonah Lehrer reminds us in his book "How We Decide”, the stock market is “a classic example of a random system. This means that the past movement of any particular stock cannot be used to predict its future movement” (p 67 “How We Decide”, 2009). And yet we delude ourselves into thinking we can see patterns of growth – a bit like contestants on the TV game show Deal or No Deal who think they can analyse which suitcase holds the prize.
Lehrer cites a study by neuroscientist Read Montague which had participants play the stock market. Unbeknownst to the subjects, the simulated market used real data from real-life market bubbles and crashes such as the Dow of 1929, the Nasdaq of 1998, the Nikkei of 1986 and the S&P 500 of 1987.
Montague found when the simulated market was in decline “people just can’t wait to get out, because the brain doesn’t want to regret staying in”. Panic sets in as people realise that their brain has tricked them into thinking they could see patterns in a random system. We are then driven by our fear of what we may lose and tend to act more impulsively rather than perhaps taking a longer term view.
Leher also profiles work undertaken by Thierry Post, a behavioural economist, who led a team analyzing Deal or No Deal. They found that once a contestant’s available options are weakened and they start receiving smaller and smaller bank offers to ‘deal’, they tend to become more risk-prone, rejecting offers that reasonable. The brain doesn’t get over the ‘loss’ of earlier, higher deal offers and so thwarts our rational assessment of the current deal proposed. The contestant digs in and plays out the game to a diminished return, lamenting what might have been. Here, rather than cashing in, the contestant holds on too long.
So in both cases, our fear of loss - our loss aversion - is what drives our decision making. In the market study, panic set in because people began to fear what they may lose, and this suggests we can sell out too early. In the Deal or No Deal examination, contestants could not get beyond what they felt they had already lost, holding on too long. This suggests we may not sell early enough. So what’s the right answer?
The right answer is to understand why you are making the decision you are. If you are selling because you fear how low the share price may fall, understand that loss aversion is driving your analysis rather than an objective assessment of the company’s performance. If you are holding on to shares just because you are angry that they used to be priced higher and you cannot bear to take a loss, consider that you may be blinding yourself to the most financial reasonable course of action, taking the deal.
As always, if you have an issue for which you would like a Behavioural Economics perspective, simply email me at email@example.com. Until next time, happy trading.