Inside the Financial Market Mindset

The second characteristic of financial assets is that they’re volatile, especially when it comes to stocks. This is because there are countless global influences on the values of these assets. As previously mentioned, the markets are run by humans, and thus exposed to human caprice. When bad news is released, shareholders lose confidence and rush to sell what they can, even if doing so will further weaken confidence and drive prices lower. Logically, this does not make sense. Unless there is a guarantee of imminent failure, investors should hold out and minimize the damage, or at the very least not trigger a collapse. But that’s like telling someone it’s okay to stay in a pool full of sharks that have been proven to be harmless. In a perceivably risky situation, emotion wins over logic.

[pullquote]Emotions, intuition, social pressures, and the volatile, abstract nature of financial assets all contribute to the context of financial decision-making. [/pullquote]

Take, for example, the UK bank Northern Rock. During the financial crisis of 2008, many banks were undercapitalized due to a global slowdown in the markets, and so many banks, including Northern Rock, had to take loans from the government. This was not because they were financially in trouble. It was merely an issue of not having enough liquidity. However, in September 2008, when news broke that Northern Rock was taking a £3 billion loan from the Bank of England, share prices plummeted by 32 per cent, causing more grief for the bank. This loss of confidence caused by a misplaced sense of risk led to a dip in share prices that snowballed into a further loss of confidence and capital. What investors should realize is that volatility is a natural byproduct of diverse decisions, and should not be a panic-inducing factor.

And finally, experiences based on financial assets are hard to learn from. The problem is that the outcomes of financial decisions are very context-dependent. The same action could produce very different results depending upon the investor, what they are investing in, and what else is happening in the world at the time of the investment. John Paulson of the hedge fund Paulson and Co. stated in a Bloomberg Businessweek interview that his firm “became overconfident as to the direction of the economy and took a lot of risk.” His firm had been using the more aggressive hedge fund strategies on which they had built their success, but the global climate prevented these strategies from working out as they had in the past. Factors such as the crisis in Europe and lack of economic rebound are part of the context in which these decisions were made. It just goes to show that context is very important, but also very problematic.

So with the psychological effects of financial assets and emotions in mind, is it even possible to make calculated trades? Yes – if you incorporate emotions into the equation. Emotions can be advantageous in making financial decisions if they are understood and regulated. Emotional regulation is an approach used by many successful, well-paid traders. A study of London traders shows that the most successful ones allow themselves to be guided by their intuition. If they get a good or bad feeling about a trade, they analyze what makes them feel that way and look at factual information to verify if their hunches are well-founded. This may seem like an easy thing to do, but this study also found that low experience traders often say they can exercise this skill, but fail to do so when the time comes. Emotional regulation? Easier said than done, especially if the trader is at the beginning of his or her career and hasn’t experienced many losses yet. These early negative experiences prove to have a detrimental effect on traders and their subsequent trades. A method often used by low experience traders to handle emotions is to back away from the situation and revisit it after the emotion has passed. Avoidance like this hinders a trader’s ability to grow and become more experienced.

There’s a myriad of reasons why financial decisions are not as rational as they ought to be. Even in a fairly theory-based environment such as the financial market, the intangible aspects of the human mind are greatly influential. Emotions, intuition, social pressures, and the volatile, abstract nature of financial assets all contribute to the context of financial decision-making. However, there are ways to harness the power of emotions, and if the psychological aspects of the market are understood well enough, it places more power in the hands of the informed investor.

Sources:

The New York Times
CBS News
BBC
Shibashake (Hubpages)

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ARB Team
Arbitrage Magazine
Business News with BITE.

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