Emotions and herd instincts are an important part of the decision-making process, particularly when decisions involve a high degree of uncertainty. This article looks at how emotional and social influences bear on decision making.
Emotional Time line: Emotions have a bearing on risk tolerance, and risk tolerance influences portfolio selection. Investors experience a variety of emotions as they consider alternatives, decide how much risk to take, watch their decisions play out, assess whether the initial strategy needs modification, and finally learn how far they have succeeded in achieving their financial objectives.
The emotions experienced by a person with respect to investment may be expressed along a emotional time line. Investment decision lie at the left end of the time line and investment goals at the right end. According to a psychologist, investors experience a variety of emotions, positive and negative. Positive emotions are shown above the time line and negative emotions below the time line. On the positive side, hope becomes anticipation which finally converts into pride. On the negative side, fear turns into anxiety which finally transforms into regret.
Hope and fear have a bearing on how investors evaluate alternatives. Fear induces investors to look at the downside of things whereas hope causes them to look at the upside. The downside perspective emphasizes security; the upside perspectives focuses on potential gains. According to the psychologist, these two perspectives reside in everyone, as polar opposites. However, they are often not equally matched as one pole tends to dominate the other. The relative importance of these conflicting emotions determines the tolerance for risk.
Herd Instincts and Overreaction:
There is a natural desire on the part of human beings to be part of a group. So people tend to herd together. Moving with the herd, however, magnifies the psychological biases. It induces one to decide on the feel of the herd rather than on rigorous independent analysis. This tendency is accentuated in the case of decisions involving high uncertainty.
The heightened sensitivity to what others are doing, squares well with a recent theory about fads, trends, and crowd behavior. In a 1992 paper in the Journal of Political Economy three writers referred to a phenomenon called information cascade. Essentially, their theory says that large trends or fads begin when individuals ignore their private information but take cues from the actions of others. Imagine a traffic jam on a highway and you find that the driver ahead you time, you are likely to follow him. Few others follow you and this in turn leads to more people imitating that behavior. What is interesting about this story is that a small bit of new information can cause a rapid and wholesale change in behavior. If even a little new information arrives, suggesting that a different course of action is optimal, or if people even suspect that underlying circumstances have changed (whether or not they really have), the social equilibrium may radically shift.
This observation appears very apt for financial markets which are constantly bombarded by new information. In such markets information cascades lead investors to overreact to both good and bad news. That’s how a stock market bubble and, in the opposite direction, a stock market crash gets started. Eventually however, the market corrects itself, but it also reminds us that the market is often wrong.
Since most investors buy at higher levels and sell at lower levels, the intelligent will have to behave contrary to the herd. It takes patience, discipline and courage to follow the contrarian route to investment success: to buy when others are despondently selling, to sell when others are avidly buying. Individuals who cannot master their emotions are ill suited to profit from the investment process.