Copycats and Contrarians

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Copycats and Contrarians Page 17

by Michelle Baddeley


  Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.24

  The preoccupation with others’ opinions and conventions destabilises financial markets. When the price we are willing to pay for a financial asset is so far removed from our own personal judgement of the fundamental value of an asset, then the herd’s judgement overall becomes flimsy and unstable. Instability is magnified particularly with short-termist, impatient speculators who want to buy then sell as fast as they can to make a quick profit.

  Emotional herding

  So far, we have focused on economic explanations for speculators’ susceptibility to social influences. Individual differences, especially personality traits, will play a role in determining whether the contrarian or copycat side dominates. As we saw above, the social learning model suggests that the balance of private and social information will determine whether a speculator is more or less likely to follow the crowd, and the well-informed professional speculators are more likely to adopt a contrarian strategy. More subjective factors will drive financial herding too, including psychological and emotional influences. For example, impulsivity is an important trigger for herding, and may connect with evolved instincts, if following the herd is an automated, instinctive response. There are also possible connections with other personality traits associated with sociability. Psychological measures of conformity and extraversion are very likely to correlate with financial traders’ propensity to follow the herd, though the extent of this correlation will depend on whether a financial trader is an amateur or a professional. Personality traits will also determine a trader’s susceptibility to emotional influences. Emotions play an important role in our financial decision-making, especially as many financial decisions involve risk-taking, which is often emotionally charged. Financial analysts are increasingly acknowledging the impact of these biological, innate and instinctive responses to stimuli on their working lives, particularly in the context of basic emotions such as greed, hope and fear.25

  External events also have an impact. Even the weather can play a part. Some economic researchers claim that financial performance is affected by seasonal mood changes: for example, Mark Kamstra and colleagues have shown that trading performance is impaired during wintertime, and attribute it to seasonal affective disorder.26 David Hirshleifer and Tyler Shumway have shown that stock market patterns around the world are correlated with hours of sunlight.27 Researchers at the Socionomics Foundation based in Gainesville, Georgia have suggested that all economic and financial instability, including financial herding, can be explained by fluctuations in social mood. Maybe this is not so surprising: social mood impacts on all aspects of our lives. Trends in music, fashion, construction and literature are all propelled by social mood.28 Bringing these insights together, social emotions, propelled by shifting moods across markets and economies, drive herding in financial markets.

  Financial herding: cognition, emotion and neuroscience

  In the case of Tulipmania, were the tulip traders caught up in one of Keynes’ beauty contests and rationally paying high prices because they thought someone else was likely to pay even more the next moment? Or were they getting carried away with the excitement of it all, driven by some fast-thinking, emotional buzz akin to addiction? Economists have disagreed over the extent to which speculative frenzies such as Tulipmania are rational or emotional.29 In reconciling the apparent contradiction, we can return to Kahneman’s dyad of System 1 fast thinking and System 2 slow thinking, and the division of effort between the two – introduced in chapter 3. If we agree that decisions are driven by more than one decision-making system, then the economist’s traditional distinction between what is rational and what is irrational becomes redundant. Speculation is neither rational nor irrational. It is more likely to be the outcome of complex interactions between System 1 and System 2.

  In fact, the idea that economic and financial thinking might reflect an interplay of different thinking systems was anticipated by Keynes. He captured how reason and emotion interact, in a battle between our rational and our whimsical, sentimental selves:

  We should not conclude from this that everything depends on waves of irrational psychology. On the contrary, [our confidence about the future] is often steady, and, even when it is not, the other factors exert their compensating effects. We are merely reminding ourselves that human decisions affecting the future, whether personal or political or economic, cannot depend on strict mathematical expectation, since the basis for making such calculations does not exist; and that it is our innate urge to activity which makes the wheels go round, our rational selves choosing between the alternatives as best we are able, calculating where we can, but often falling back for our motive on whim or sentiment or chance.30

  How can we measure these interacting thinking styles to analyse the links between emotions and financial herding? As we noted in chapter 3, with conventional economic analysis, data about people’s observed choices is relatively easy to collect. There are many large databases around the world showing the volumes of assets traded and the prices paid for them. Yet, although they record actual decisions, these databases cannot record the interactions of cognition and emotion that drove the decisions. Capturing these underlying influences on financial traders’ decisions is becoming easier as neuroscientific techniques improve.

  As introduced in chapter 3, neuroscientists link financial decision-making with the neuroscientific evidence by showing that money stimulates the same neural reward-processing systems activated by the pursuit of rewards such as food, sex and drugs. In one study, researchers monitored professional derivatives traders’ physiological responses while they were engaged in risky gambles. The traders experienced heightened emotional states, measured in terms of elevated heart rates, muscular responses, high blood pressure, rapid respiration rates and elevated body temperature. Experienced traders were generally better at controlling their emotions.31 In another study, researchers examined people with brain damage in specific neural areas including those usually associated with emotional processing, such as the amygdala and insula. People with damage to their neural emotional processing circuits were more willing to take risks by investing money in gambling tasks. They also made larger profits than the experimental subjects in a control group, perhaps because decreased affect ameliorates problems created by more impulsive decision-making. We explored above why speculators may be inclined towards myopia and short-termism in their buying and selling decisions. They are excessively preoccupied with ephemeral, day-to-day fluctuations. This interacts with their fear of losing money through their trading activities – reflecting the phenomena of loss aversion explored in earlier chapters. Nobel Prize-winning behavioural economist Richard Thaler, working with his colleague Shlomo Benartzi, brought together insights about myopia and loss aversion by identifying a financial decision-making anomaly: myopic loss aversion. Myopic loss aversion is a bias that emerges when speculators are simultaneously too focused on the short term and excessively preoccupied with losing money. It distorts the balance between risky equities (e.g. shares in companies) and safe bonds (e.g. bonds representing a piece of government or corporate debt). Why is it so distorting? If financial markets are working well, we would expect speculators to buy into assets that have higher returns, but, because of myopic loss aversion, speculators worry excessively about losing money quickly if they buy equities and so they buy fewer equities than they need to maximise their profits. Instead, they are disproportionately inclined to buy bonds, even though returns on bonds are lower. The differences in returns on equities versus bonds are not traded away, and traders do not maximise their profits.32

  The social influences we have explored in this chapter increase the intensity of speculators’ emotional responses, and this can be seen in financi
al markets when social conventions encourage speculators to believe what others believe and to do what others do. Emotions are processed much more quickly and easily than quantitative and mathematical information, and they spread more quickly through the herd, magnifying financial instability. Drawing on similar insights, some economists describe phases of boom and bust as manic-depressive episodes, driven by emotions. As American economist Hyman Minsky observed in the 1980s and 1990s (well before the financial instability of 2007/08), during an economic boom, speculative euphoria spreads quickly through entrepreneurs, investors and bankers, catalysing surges in construction activity and financial bubbles. But because the bubble is unstable, it can quickly burst. Individuals panic, and their panic spreads. As negative unstable forces take hold, economies and financial systems lurch into crisis, with excessive pessimism and extreme risk aversion precipitating bust phases. As we explore in more depth below, Minksy’s analysis predicted that recession and depression would emerge in the aftermath of a perfect social storm of risk, anxiety and fear.33 Minsky’s analysis chimes with recent evidence from psychological studies suggesting that interactions between risk, emotions and herding intensify fearfulness and trigger social panics. Panicking individuals precipitate panic through the herd.34

  Entrepreneurial mavericks

  In the previous chapter we discussed different types of mavericks – people who are prepared to take risks with new and different ideas. Economies are driven by two specific types of mavericks: inventors and entrepreneurs. Inventors are a classic type of maverick and their novel inventions are fed into the economy via another set of mavericks: entrepreneurs. Entrepreneurs are prepared to take risks in turning an invention into an innovation and then into a marketable product or service. The renowned economist Joseph Schumpeter captured something of how herding and imitation drive innovation and entrepreneurship in the economy. For Schumpeter, innovative entrepreneurs are heroes. They are the lifeblood of a successful capitalist economy and, when they introduce a new business idea, they attract swarms of imitators who want to copy them. At the outset, many of these imitators will benefit from the profits the new innovation brings, but eventually, when the swarm of copycats grows too large, the benefits will disappear, and the economy as a whole will head into a downturn.35

  Another famous account of maverick entrepreneurship comes from John Maynard Keynes in The General Theory of Employment, Interest and Money:

  it is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism . . . For it is in the essence of his behaviour that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness; and if . . . he is unsuccessful . . . he will not receive much mercy . . .36

  Keynes also emphasised the far-sighted nature of entrepreneurship. Ephemeral influences will not help entrepreneurs to make good decisions, especially as the rewards from good business ideas are unlikely to emerge over short time horizons. Keynes observed that an entrepreneur is unlikely to be able to calculate the future prospects of their business projects because the future is inherently uncertain – and so entrepreneurs need to be forward-looking and optimistic. Entrepreneurs realise that it takes time to generate profits and so have a patience that financial speculators often seem to lack, especially in new, innovative industries. Facebook, Instagram and Twitter are all examples of innovative businesses which did not immediately deliver revenues and profits, yet their founders had a vision of what their companies could become in the future. During the dot-com boom of the 1990s many businesses failed – and perhaps their founders were also forward-looking mavericks, just unluckier or with an inferior product.

  Uncertainty about the future constrains effective decision-making by maverick entrepreneurs, but they are less susceptible to herding than most speculators. Building a business is not usually about sitting down with the accounts and making an arithmetic calculation of likely future profits, partly because it is difficult to predict the future and the information needed to make such calculations just does not exist. Entrepreneurs are not looking to make money out of short-term fluctuations in fast-moving markets. Social learning, reputation, beauty contests: all these factors have a lesser impact on entrepreneurs than on speculators. Entrepreneurs look to the long term, and so the short-termist opinions of others around them are not so relevant. Overall, the contrarian entrepreneur is less vulnerable to herding’s negative impacts than the consensual speculator. Instead, entrepreneurs rely on their internal intrinsic motivations, and they take an optimistic view of what might happen.

  Social influences are not irrelevant to entrepreneurs, but they affect them in different ways. Daron Acemoğlu explored social information from the perspective of entrepreneurial investors in his model of signal extraction. Entrepreneurs extract signals from macroeconomic data, for example data on fixed asset investment – the money spent on things like machinery and buildings – making inferences about what other entrepreneurs are deciding using this aggregate information. This helps each individual business person to judge a situation, such as the wisdom of investing in a new business. In a macroeconomic corollary of the self-interested herding models we explored earlier, aggregate information helps individual entrepreneurs to infer what other entrepreneurs are doing.37 By looking at aggregate data about what everyone is doing collectively, entrepreneurs can extract signals about likely future prospects of their new business ventures.

  Entrepreneurial emotions

  Entrepreneurs’ far-sightedness does not mean that they are immune from psychological influences. A recent study into small businesses in Africa has shown that psychological traits associated with initiative-taking and goal-setting are associated with better business performance than traditional business education.38 Another feature of the entrepreneurial personality is that entrepreneurs are likely to be people of action with a strong urge to do things differently – a reflection of their contrarian natures. When they bring new innovations to the marketplace, entrepreneurs are motivated not only by the profits they might earn, but also from the psychological satisfaction they get from building a business. They have stronger maverick inclinations and are more likely to be propelled by gut feeling and other emotional and psychological influences into getting something done. Keynes describes entrepreneurial mavericks thus:

  Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits – a spontaneous urge to action rather than inaction . . .39

  This concept of ‘animal spirits’ links back to the ancient Greek physician Galen, first introduced in chapter 3, and his analysis of four temperaments. In developing his concept of animal spirits, Galen followed in the footsteps of Hippocrates, another renowned ancient physician and philosopher who postulated that our behaviour is driven by four ‘humours’, each of which was linked to four essential elements: black bile to earth, blood to air, phlegm to water and yellow bile to fire. Galen developed Hippocrates’ schema by linking each of these humours to a different temperament: black bile is melancholic, blood is sanguine, phlegm is phlegmatic and yellow bile is choleric.40 Related to these humours, Galen popularised the idea of ‘animal spirits’. These are something like a sub-category of neurotransmitters, the chemical messengers that flow around our body, through the nerves, and help its functioning. For Keynes, ‘animal spirits’ were a way of conceptualising entrepreneurs’ sanguine temperament. He observed that ‘investment depended on a sufficient supply of individuals of sanguine temperament and constructive impulse who embarked on business as a way of life’.41 Whilst Galen’s ideas seem naïve from a modern medical perspective, Keynes’ saw animal spirits as a means of explaining the positive attitude of entrepreneurs towards innovation as investment, now a focus of modern models of behavioural macroeconomics, as we shall see.

 
; Ecology: copycat–contrarian symbiotics

  We can see easily that entrepreneurs are valuable players in our economy. They produce things. They employ people. They don’t worry what everyone else thinks. The importance of speculators to our economy is less obvious because they do not produce anything physical of value themselves. So, why do we need them? They are the inevitable product of the financial markets on which entrepreneurs depend. Financial liquidity is important for any entrepreneur looking to build or sustain a business venture, and fast-moving financial markets can help entrepreneurs to raise money quickly for new investments. Before the advent of modern financial markets, if an entrepreneur wanted to invest in a new business they would have had to either raise funds from their own resources or go to a bank. With stock markets, they can access finance much more quickly. Entrepreneurs need financial markets and financial markets need speculators to keep the money moving around. For this reason, entrepreneurs and speculators have developed a symbiotic relationship.

 

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