It is hard to believe that stock prices are being driven by a rational assessment of value. Investors seem to be relying on the same primitive emotion that made our forebears on the savanna bolt when approached by a hungry lion: fear.
Of course, fear can be rational, as the experience with the lion might suggest. But the dynamics of the financial mess suggests that — on the way up and on the way down — investors, regulators, policy makers and homeowners have been operating by gut-driven nostrums rather than hardheaded analysis of facts. Behavioral economists politely refer to this as cognitively flawed heuristics.
The world is a complex place, so it’s understandable that we’ll try to master it by using simple rules. The problem is they are often wrong — like the incorrect yet popular belief that past behavior, say soaring house prices, is a good guide to future performance. Unable to make quantitative judgments about risky propositions, we often decide based on the best and worst possible scenarios regardless of their probabilities. That leads to binary decisions like going all in when the going is good and pulling out in panic when the tide turns.
These quirks are magnified by our well-known tendency to herd. We use other people’s behavior to validate ours — allowing ourselves to believe that housing is a good investment because our neighbor does.
There are such things as well-thought-out financial runs. The gyrations of the Bank of America stock might be caused by rational investors trying to puzzle out whether the bank will survive the crisis in good shape.
Even the rise and fall of American housing finance could be spun as a tale of flawless logic: homeowners and banks bet on reasonable forecasts that home prices would continue to rise. When they didn’t, defaults rose and banks became insolvent. Other banks ceased lending to them. Investors sold bank shares. The End.
I don’t think so. There is another big psychological distortion to account for: our tendency to believe our own theory of the world. Consider the former Fed Chairman Alan Greenspan’s repeated insistence during the housing price run-up that there was nothing to fear. Though he once warned about irrational exuberance, Mr. Greenspan lived by the belief that unfettered markets always lead to optimal outcomes.
“Not only have individual financial institutions become less vulnerable to shocks from underlying risk factors, but also the financial system as a whole has become more resilient,” he said in 2004. After the past few weeks, he might want to reconsider.