Journal Article

No. 2009-40 | November 20, 2009
Addressing the Psychology of Financial Markets PDF Icon

Abstract

The author suggests that the 2008 financial crisis was the culmination of an accelerat­ing and inherently unstable process of financial market evolution. He argues that markets are not well organized to manage the power that financial assets have to generate emotion and their wider effect on human imagination and judgement, anchored in neurobiology. Judgements and decisions about risk, reward and the evaluation of success can become systematically compromised because the excitement of potential gain is disconnected from anxiety about potential consequences, producing groupthink and bubbles. When anxiety breaks through, a catastrophic loss of confi­dence is inevitable. In the aftermath the emotional pain that would be involved in accepting responsibility stands in the way of lessons being learned.

The author’s theoretical framework is influenced by modern psychoanalysis and draws on an interview study of international fund managers in 2007. He suggests that underlying psychological conflicts have influenced the way market institutions have evolved to compete by selling the promise of exceptional performance. To cope with the expectations upon them, agents are impelled to base their actions on stories which overvalue opportunities and underestimate risks; this creates agency issues and facilitates the process of disconnecting anxiety from excitement that creates bubble potential. Policy implications go well beyond improving regulation and transparency.

 

JEL Classification

G28 G18

Citation

David Tuckett (2009). Addressing the Psychology of Financial Markets. Economics: The Open-Access, Open-Assessment E-Journal, 3 (2009-40): 1—22. http://dx.doi.org/10.5018/economics-ejournal.ja.2009-40

Assessment

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Comments and Questions


Gerhard Schroeder - Derivatives should be handled like untested medicine
November 25, 2009 - 21:00

Pricing formulas like the Black-Scholes one have quite some defects – mathematically as well as economically. Unfortunately the usage is widespread.
The accounting standards covering future pricing (IAS 39, IFRS 9, AG 69-82, pls refer to the IAS Board in London) allow nearly everything – ok, may be not the ...[more]

... Pythagoras
Volatility is the key factor of any option pricing formula. Volatility indexes describe the market heat. They are derived from indexes like DJ, S&P, FTSE, Nasdaq and DAX are published several times per day. The funny finding is that these volatilities are quite similar to those measured as standard deviation for the last 9 weeks.
It is obvious that this type of pricing (and reporting via IAS/IFRS) allows several degrees of freedom and „design“ of reports and balance sheets.
It’s a belief that current volatility influences future values. Instead, the swell doesn’t change the depth of the sea.
The B&S-Formula requires constant volatility. However, all known financial data is not homoscedastic, volatility is not constant. And, 1 percent of volatility results in serverall percent of price increase. This makes the „potential for very large increases or decreases in value at any time“ as Tuckett says.
The moment of truth is at expiration date. Formula pricing is legal in between (unfortunately). The „significant doubts about the mathematical models of theoretical risk...“ as mentioned are not because of the risk but mainly because of the pricing. The risk assessment is more or less reduced to the current quotes plus/minus the volatility describing the potential bandwidth for the next year.
There are indications that future markets are based on kind of religious belief: When the majority of the market participants believes in the B-S-framework - no wonder that the pricing follows that line. I would even say the B-S-framework is a kind of „intelligent design“. I am in line with „modelling is not for their “truth” but for their comfort value...“
What caused the 1987 crash? „no new information“? – One explanation was that computer trading – made possible by the B-S-formula – resulted in rapid declining rates. (This was solved later by stopping orders in case of more than 1 point index decline within a minute and similar smoothing rules. )
I like to join the suggestions e.g. to treat certificates like new medicine to exclude the toxic ones.. A singl German Bank „emits“ 2000 certificates per day / more than 20 K per month.
“Temperature” checks (and cooling) would be a good approach to soften the markets. 5 to 10 percent would be a reasonnable temperature. It’s the volatility of foreign exchange markets. Any higher volatility should be smoothed by increasing the minimum order volume. It shouldn’t be lower either. The compass needle should move a little indicating that there is no blockage.