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Sunday, June 28, 2009

Scientific American: Bubbles and Busts

by Calculated Risk on 6/28/2009 02:03:00 PM

Scientific American has a discussion of behavioral economics (Shiller's area) in the July issue. Here is a funny quote:

“Economists suffer from a deep psychological disorder that I call ‘physics envy'. We wish that 99 percent of economic behavior could be captured by three simple laws of nature. In fact, economists have 99 laws that capture 3 percent of behavior. Economics is a uniquely human endeavor ..."
Andrew Lo, a professor of finance at the Massachusetts Institute of Technology
It probably isn't as dismal as Lo suggests!

Here is the article from Scientific American: The Science of Economic Bubbles and Busts (ht Jonathan) and a short excerpt:
... [T]he ideas of behavioral economists, who study the role of psychology in making economic decisions, are gaining increasing attention today, as scientists of many stripes struggle to understand why the world economy fell so hard and fast. And their ideas are bolstered by the brain scientists who make inside-the-skull snapshots of the [ventromedial prefrontal cortex] VMPFC and other brain areas. Notably, an experiment reported in March ... demonstrated that some of the brain’s decision-making circuitry showed signs of money illusion on images from a brain scanner. A part of the VMPFC lit up in subjects who encountered a larger amount of money, even if the relative buying power of that sum had not changed, because prices had increased as well.

The illumination of a spot behind the forehead responsible for a misconception about money marks just one example of the increasing sophistication of a line of research that has already revealed brain centers involved with the more primal investor motivations of fear and greed ... A high-tech fusing of neuroimaging with behavioral psychology and economics has begun to provide clues to how individuals, and, aggregated on a larger scale, whole economies may run off track. Together these disciplines attempt to discover why an economic system, built with nominal safeguards against collapse, can experience near-catastrophic breakdowns.
The behavioral economists who are trying to pinpoint the psychological factors that lead to bubbles and severe market disequilibrium are the intellectual heirs of psychologists Amos Tversky and Daniel Kahneman, who began studies in the 1970s that challenged the notion of financial actors as rational robots. Kahneman won the Nobel Prize in Economics in 2002 for this work; Tversky would have assuredly won as well if he were still alive. Their pioneering work addressed money illusion and other psychological foibles, such as our tendency to feel sadder about losing, say, $1,000 than feeling happy about gaining that same amount.

A unifying theme of behavioral economics is the often irrational psychological impulses that underlie financial bubbles and the severe downturns that follow. Shiller, a leader in the field, cites “animal spirits”—a phrase originally used by economist John Maynard Keynes—as an explanation. The business cycle, the normal ebbs and peaks of economic activity, depends on a basic sense of trust for both business and consumers to engage one another every day in routine economic dealings. The basis for trust, however, is not always built on rational assessments. Animal spirits—the gut feeling that, yes, this is the time to buy a house or that sleeper stock—drive people to overconfidence and rash decision making during a boom. These feelings can quickly transmute into panic as anxiety rises and the market heads in the other direction. Emotion-driven decision making complements cognitive biases—money illusion’s failure to account for inflation, for instance—that lead to poor investment logic.
I've argued before that many buyers during the late stages of the bubble acted rationally. They could buy with little or no money down, and their house payments were below the comparable rent for a couple of years . If prices went up, they could sell as a profit - and if prices went down, they could strategically default. That was a systemic problem.

But animal spirits definitely helps explain the rush to buy that we saw at the peak of the bubble.

As an aside, I highlighted the one sentence because I've seen that behavior frequently. Some people are so afraid of losing money on each investment that they pass up on some very good investments. These individuals appear to assign a higher value to losing $1000, than gaining the same amount.