"[T]he values to which
people cling most stubbornly under inappropriate conditions are those values
that were previously the source of their greatest triumphs."
- Jared Diamond, Collapse:
How Societies Choose to Fail or Succeed
In Collapse: How Societies Choose to
Fail or Succeed, Jared Diamond (UCLA professor of Geography) described
the collapse of civilizations as a gradual environmental process, fueled by
systematic behavioral weaknesses evident in inertia and short-term thinking,
culminating in a rapid unwinding too rapid to stop. As he describes it,
as environmental stress increased in prior failing societies, social and economic
disparities widened. Rather than looking to identify empirical causes and
create functional solutions to save themselves, these societies fractured
along political and class lines. As stress increased, the various factions
hardened their tactics, ultimately physically attacking internal political
enemies and igniting civil wars which destroyed the social and cultural mores
that upheld institutions.
I was reminded of Diamond's thesis a few weeks ago in Canada, of all places.
I was in Toronto's financial district when I was handed, with a direct and
sincere look, a manifesto on the evils of capitalism.
Now, when I lived in San Francisco and Austin (two cities I love), I often
received such manifestos - usually followed by some unsolicited recommendations
regarding marijuana cultivation or freeing Tibet. It was all fairly benign.
But the Toronto pamphleteer was not unhinged, malodorous, or intoxicated - he
was sincere, healthy, and appeared overtly rational. His apparent
reasonableness shocked me more than the manifesto itself: A reasonable man
pushing an overthrow of capitalism. That same night, student riots in
Montreal over tuition
increases led to the arrest of 122.
Democratic governments in the developed world have borrowed money to finance
their promises. Without displaying adequate performance. As a
result, voters are disappointed and angry, and now inclined to try extreme
alternatives.
While I'll discuss social collapse in light of Greece this week, I think we
should also take this opportunity to look at our own societies. The
unraveling has already begun. What can we do to prevent a similar meltdown?
I consider myself optimistic, so it pains me to return to the topic of
collapse. That said, I'm of the opinion that facing an ugly truth sooner
allows us to have a happier life later. Sadly politicians have the incentive
to avoid hard choices in the short term, and as a result the pain of collapse
will be that much greater.
New public policies that
account for human (and elected official) psychological weaknesses are
desperately needed. Fortunately, such an effort has begun. Read
on to learn more.
But first, some
housekeeping...
Istanbul, Toronto, London, and Las Vegas
|
In the past month we've been
speaking and training in Toronto, San Diego, Quebec, Las Vegas, and Istanbul
(what a lovely city!), and we'll be in London,
Las Vegas and Quebec (again) in the next 30
days. The London News Analytics
Roundtable in
Canary Wharf on June 18th is
a must-attend if you use sentiment data. We look forward to catching up
with our friends in those cities.
We still haven't launched our weekly investment newsletter,
but we're on the verge (just two more weeks)! Click here to receive our weekly investment strategy newsletter (if you already requested the Newsletter,
then this step is unnecessary). We've
been intensively expanding our data architecture in order to capture even
more interesting data and predictions to share with you.
We will also be adding separate financial advice and global
social commentary in separate monthly newsletters. More about those as
they prepare to launch.
I'll be relocating to the New York City area this
summer. It has been wonderful in California, and I hope to return to
the San Francisco area soon - but for now family and clients bring us East.
|
Fearmometer
June 12,
2012
Recent Press
For Financial Advisors:
Advisor One. April 26, 2012.
|
Peek-a-boo, Object Permanence,
and the Surprising Event That Couldn’t
|
Last year I commented to an
acquaintance of mine in Europe, "I wonder how long until the Euro falls
apart?" He dismissively remarked, "The Euro won't
dissolve. It can't." When I asked why it can't, he explained,
"Well, what would happen then? It's impossible." This
line of reasoning is a bit like telling Columbus in 1492, "No one knows
what is over the horizon, therefore you cannot sail that way." This
flawed logic reflects a psychological stage of child development called object
permanence.
Object permanence describes an infant's growing recognition
from birth to age 2 that objects
he or she cannot see, hear, or touch are still existing. The concept of
object permanence explains why peek-a-boo is such a hilarious game for
infants. When you disappear behind a couch, they truly feel, "Oh,
how disappointing!" And then you suddenly jump up and reappear,
prompting a happy revelation: "He's back, what a thrill!"
And giggling ensues.
Adults have a similar problem
with inconceivable outcomes - if a potential outcome is too complex or
unprecedented, we ignore it (and don't prepare for it) because it is
impossible. As an adult might say, "It is impossible for countries
to leave the Euro because the consequences are unfathomable." This
statement is a bit like a child playing peek-a-boo - if I can't conceive it, then
it doesn't exist in the realm of possibility.
The last four years we've been
playing peek-a-boo with the specter of first Greek default and then Greek exit
(Grexit) from the Euro. Every six months the specter pops up again, and
markets react with the same incomprehending fear until a stop-gap is agreed
upon.
Catastrophizing or Total
Disaster?
|
The fear of Grexit and
financial Armageddon caused credit markets to freeze - as European credit
markets did the past few weeks. Each time this has
occurred previously in the past 4 years, governments step in as counterparties,
the specter of crisis dives behind the couch, and the market's short-term fear
is dissipated.
Every time credit markets
freeze, a catastrophic concern emerges - that this time the specter will
"get us" and financial collapse truly will ensue. The concern
is a logical one that arises from experience with herd behavior: If you
are a lender, and your peers are also beginning to restrict credit, then you
yourself are incentivized to stop lending. No one wants to be caught
holding the bag. So each lender tries to stop lending first. This
cycle is repeated every six months and is only stopped by a convincing
short-term response from political leadership.
Our news and social media
monitoring software shows this cycle in conversations about Greece. In
Greece, the focus of anxiety is shifting over time. In the image below,
all lines represent levels of conversation about Greece specifically. In
the image are significant spikes in chatter about Greek Unemployment beginning
in Spring 2009 (blue line), in late 2009 Fear rises in conversations about
Greece (pink line), and in April 2011 a Greek Debt Default becomes a real
possibility according to the media (red line). Was it the rise in
unemployment that ultimately sparked high stress in Greece? As fear
remained high around Greece, more extreme events were facilitated.
Ultimately, debt default became more concerning, and then occurred.
SOURCE: Aleksander Fafula, PhD
As we described in our
webinar last Fall, democratic citizens will not
vote for politicians who keep the pain coming. Witness Sarkozy's loss,
the rise of Tsipras in Greece, and the surprising success of the brutal Greek
far right party - the Golden
Dawn. So what will a stressed public do? They will vote for severe
short-term pain ("rip off the band-aid" therapy) in order to escape
the cycle of continued slow suffering. This is capitulation, a precursor
of economic collapse.
Overestimating
Low Probability Negative Events
|
Cognitive
psychologists have identified numerous emotional biases that distort our
thinking when we are feeling stress. These biases have self-explanatory
names such "black-and-white thinking",
"over-generalization'", and "catastrophizing." Catastrophizing
is the bias I'd like to use to illustrate what is happening to the thinking of
the European public. Catastrophizing refers to overestimating the odds of
severely negative events happening.
Catastrophic
thinking has its roots in our genes and neurochemistry. Think about
it: it was better that our ancestors over-estimated the odds of a
disaster than underestimated. They would have been culled from the gene
pool if they were under-prepared for potential danger, if it actually
struck. As a result, we are descended from "Nervous Nellies."
We are hardwired to think the worst in dangerous situations.
The most
apparent example of catastrophization occurs in the way we estimate
probabilities of unlikely, but potentially severe, events. The image
below depicts our overestimation of small probability negative events.
"Affect-rich" refers to the odds we place on events that have vivid
and emotional signs, like riots and burning buildings in Greece.
"Affect-poor" refers to the odds we place on objective, boring
events, like the chance the next Euro notes will have a picture of the
Copenhagen-Malmo (Øresund) Bridge. As the curved line deviates above the
straight diagonal line, it represents the increase in estimated probability
above the actual level for Affect-Rich (high emotion) events. Affect-Poor
events are also overestimated, but less so.
Fortunately,
we do not have to be passive victims of our own catastrophizing.
Cognitive psychologists have found that we can consciously supplant anxious
thoughts with unbiased and objective thoughts, thus reducing the core emotion -
anxiety - and interrupting the positive feedback loop and mental
"spinning" that anxiety causes. Consciously thinking unbiased
thoughts acts to calm anxiety, and thus we can intentionally modify our
thoughts via cognitive therapy techniques, reducing biases such as
catastrophizing.
In the
case of Greece and the Euro-zone, it's important to keep this in mind as the
crisis intensifies. We are all emotionally primed to feel anxious by the
media. As investors, however, it is key to remain objective (and
contrary) about the herds' emotion. The best way to remain objective is
to consider the cognitive processes that have already and that will unfold
among European leaders, voters, and investors. The four Researcher's
Corner sections below articulate findings that shed light on how humans
repeatedly get into bad financial situations through short-term thinking, why
we "kick the can down the road" to avoid short-term pain while
risking longer-term disaster, and how a final capitulation occurs.
Researcher’s
Corner: Self-Control
|
This May Harvard behavioral
economist David Laibson gave a fascinating talk at UCLA about some of his
latest behavioral research. Dr. Laibson is well-known academically for
adapting a hyperbolic discounting model (the beta/delta model) to describe how
people make saving, spending, and investing choices. He's also done
terrific work on cognitive decline and financial decision making, which we cite
in our MEMRI script for
financial advisors.
In his recent UCLA talk, Dr.
Laibson described research he performed with John Beshears (of Stanford) and
colleagues. They tested a model of savings in which subjects were given a
choice of a "liquid" savings account (they can withdraw money at any
time) versus a savings account with an early-withdrawal penalty. After
one year, the subjects who kept their money in either savings account would
receive the original savings plus a 22% return. The researchers tested
several combinations of punishments for the early-withdrawal condition.
Some could choose to receive their experimental earnings either in the freely
liquid account or in the one with a 10% early-withdrawal penalty. Another
group could choose between the liquid account and an account with a 20%
early-withdrawal penalty. A third group chose between the liquid account
and an account with no ability to withdraw funds until the year was up (a
lock-up account). Remember, the subjects received a 22% annual return on
their savings in whichever account they chose.
Rational expectations theory
assumes that people have perfect self-control, and as a result they should
choose the fully liquid account option (in case of an emergency or a higher
available return, they could then withdraw the saved money for that
purpose). Contrary to rational theory, many people chose to use the
penalty-accounts with the percentage choosing the penalty accounts increasing as the potential penalty
increased. More than 20% of subjects chose the 10% penalty account in the
first group. In the second group more than 30% of subjects the 20%
penalty account, and in the no-withdrawal condition more than 50% of subjects
chose this account for their savings versus the liquid account. Many people voluntarily chose future
punishment in case they withdrew their money early. Technically speaking,
people will chose the threat of punishment against their future selves in order
to enforce self-control on them.
So we know that we are weak at exerting
self-control over our savings. Are our government leaders equally as
weak? There is no checks-and-balances system set up to prevent
politicians from over-spending. Yet in a democracy, elected officials
have an extra incentive to boost spending for their constituencies in advance
of voting. The result of such overpromising is that social security and
healthcare promises are easy to make before elections, but eventually those
promises come due. The developed world is now faced with an obvious
negative predicament - our future promised liabilities far exceed our ability
to pay them. Most governments can print money to fund liabilities (a
stealth tax via inflation) and use stimulus measures, but there is moral hazard
with such a solution - the fear that there is no end to such printing by
elected politicians once it is made morally acceptable. Yet fiscal
austerity creates short-term pain, and if it does not lead to growth within a
2-year election cycle, then it is often abandoned by politicians promising easy
fiscal solutions (stimulus). So what can we do to break this cycle?
To understand solutions, we must first understand how we got into this
position.
Researcher’s
Corner: Moving from Hope to
Capitulation
|
Psychologist Daniel
Kahneman shared the 2002 Nobel Prize in Economics for his development of
Prospect Theory with Amos Tversky. Prospect Theory is a model of
decision-making under risk, based on experimental evidence (in contrast to most
economic theories), that describes how people decide when faced with
potentially negative outcomes (risk).
It turns out that
people behave very differently depending on their "reference points"
(essentially, their expectations). For example, when people are in a bad
situation, and they have hope of recovering via perseverance, they generally
INCREASE their risk-taking. This increase in risk-taking is also
called "doubling-down" and is driven by what Hersh Shefrin and Meir
Statman called the disposition effect (a.k.a. "breakeven-itis" - the
desire to get back to a neutral position). This is the psychological
process that drives that bane of traders, "holding onto losers too
long." Holding onto losing positions too long (in the form of
"throwing good money after bad" and the "sunk cost" bias) is
also a scourge of taxpayers and is seen in expensive never-ending over-budget
military projects like the "stealth bomber" and infrastructure
projects like "the Big Dig" in Boston.
The Euro-zone has so
far thrown tens of billions of good money to Greece (and now $125 billion to
Spanish banks) with the hope that after receiving this money, Greece would
reform. Greece not only did little to reform its tax code or pensions
system, but also many Greek voters spurned the bail-out, labelling it German
imperialism. Europeans might justifiably feel a bit angry by the
intransigence of the Greek government. And it is this anger, as it gives
way to hopelessness, that will reset the European reference point
(expectations) from hope to despair - from potential recovery in Greece, to
Greece as a lost cause.
But while hope has
given way to despair regarding Greece, there is still - on balance - hope that
the remaining members of the Euro-zone can find a solution for themselves.
Researcher’s
Corner: Buy on the Rumor, Sell on the News
|
Neuroscientist Wolfram Schultz
demonstrated that our brain's learning mechanism is fueled by one of the
brain's dopamine circuits (the meso-limbic, which runs through the reward
system). Interestingly, this system is most responsive to expectations
(the reference point). When expectations are increased by rumors or
potential positive events, a surge of dopamine is released. When the
expected event happens, if it is in line with expectations, then the dopamine
level does not change.
When rumors of a Spanish bank
bail-out hit the news, world financial markets rallied and finished last week
as their best week of 2012. The reward systems of traders were excited by
the anticipation of some relief. After the Spanish bank bailout was
announced, European markets gapped up on the good news but ultimately sold off,
down more than 1% for the S&P 500 by end-of-day. So what happened?
When positive expectations are
met (or worse, disappointed), then the dopamine system deactivates, leading to
decreased dopamine activity and decreased risk taking. In the case of
traders, such deactivation from calmed expectations leads to selling.
Below are Schultz' images of
how the brain's dopamine neurons in the reward system respond to rewards
("Reward") and how they respond when expectation of reward are set
("Stimulus"). Notice that the frequency of dopamine neuron
firing increases in the second image when the stimulus is received (and
expectations are set), but decreases very slightly when an expected reward is
received. Dopamine firing pauses entirely in the third image when the
expected reward is not received ("no reward").
SOURCE: Schultz, W.
2011. “Potential Vulnerabilities
of Neuronal Reward, Risk, and Decision Mechanisms to Addictive Drugs.”
Schultz' work is relevant to
the Euro crisis because it can trace much of the price volatility to the fear
of disaster, then expectations of short-term salvation (saving the Spanish
banks), then disappointment when expectations are met (or disappointed), and
finally the next crisis looming into view. When Euro-zone leaders meet,
expectation (and hope) is high that they will present a coherent plan.
When they do not present a workable plan, markets plummet. Sometimes
European leaders surprise with temporary relief measures, and the markets rally
for a few months until it again becomes clear that Euro-zone economies are
worsening, thus necessitating further bail-outs.
This cycle of
expectation-setting, disappointment, and relief is emotionally exhausting for
market participants. More importantly, it becomes exhausting for the
European public and the leaders themselves. Such exhaustion leads people
to try to escape from the noxious situation. If positive means of
resolution are not found after 2-3 years, then drastic measures are viewed as
more desirable - anything to "stop the pain", including more severe
short-term pain as long as some ultimate relief can be seen on the horizon.
As long as there are multiple
potential outcomes (uncertainty), investors will shun European equities and
bonds and eventually the Euro. At this point, a workable plan will
involve political and budgetary check-and-balances, if not a direct political
union, to balance the monetary union. Once that uncertainty is
resolved (a "probability collapse" in psychological jargon), a real
relief rally will ensue.
Democracy
and Financial Self-Control
|
The founders of the United
States appeared to understand the human psychology of power (and the ease of
corruption). As a result they designed a governmental system of checks
and balances between the executive, legislative, and judicial branches to
prevent excess power in one branch.
Yet democracy can be
undermined by excessive short-term thinking with finances and budgets.
There is no legal check on the power of legislators to over-promise and
overspend, and voters have little ability to understand (nor react
appropriately to) fiscal profligacy among leaders.
Fortunately a group of UCLA
behavioral economics researchers founded a behavioral policy journal to
stimulate ideas and research in improving public policy through an
understanding of behavioral incentives. The journal's founders also
provided the Obama campaign with strategic tips on boosting fund-raising.
The George Clooney celebrity dinner? Yes, behavioral
economics-inspired. The lottery for a "regular-guy" seat to
that dinner? Also behavioral economics in action. One enjoyable
aspect (perhaps the only pleasant part?) of this year's U.S. presidential
contest will be watching behavioral strategy employed. We've expanded our
text-analytic software to include political figures, so we'll keep track of the
major races this year out of personal curiosity and will keep you posted on our
findings.
Clearly there is a lot of fear in Europe. Below is an
image of the amount of Fear expressed in all news reports about Italy versus
the United States through January 2012. For several years Italy managed
to avoid the contagion of the Euro-zone instability. But now fear is
squarely on Italy's doorstep.
Because of such fear in the
Euro-zone, investors have fled in droves. The Economist Magazine recently
noted that European equities are trading at an average P/E ratio of 11, while
U.S. equities have a P/E of 18. As a result, European stocks are
"cheap", and once the uncertainty is resolved, a massive rally may
ensue. Southern European bank stocks are a call option on a Euro-zone
reconciliation, but there is a risk of nationalization of dysfunctional banks.
Financial firms that were indiscriminately sold alongside European
banks, such as insurers and brokerages, are better investments.
In the short-term, the next
anticipated event is the Greek election of June 17th. The outcome is
uncertain, but a favorable short-term result (favorable for Greece to stay in
the Euro) is likely. That said, Germany still must decide whether or not
to deliver additional bailout payments, and given Greece's lack of tangible
progress in reforming their tax collection system and pensions, additional
bailout funds are uncertain.
Ultimately, the European
volatility will continue, to be followed by an acrimonious American
election. Yet as Warren Buffett has said, "The future is never
clear, and you pay a very high price in the stock market for a cheery
consensus. Uncertainty is the friend of the buyer of long-term values."
That said, any relief rally
will likely last for months of duration (not years) and then stall. The
demographic headwinds facing Europe are significant long-run drags on the
equity markets and economic growth. The uncertainty developed world
markets face is more fundamental than at any time since the Second World War.
Keep your chin up - this summer
is a time to be thoughtful and opportunity-seeking during the short-term waves
of anxiety as they sweep over markets.
We love to chat
with our readers about their experience with psychology in the markets - we
look forward to hearing from you! We
especially love interesting stories or your or others experiences.
Happy Investing!
Richard L.
Peterson, M.D. and The MarketPsych Team
Books
Both books named "Top Financial Books of the Year" by Kiplingers.
