However much the many macroecnonomic metrics across all accounting statements can be analyzed, and reveal important information about particular companies, there is in fact a much more altruistic force behind microeconomics. Beyond the numerous processes that occur between macro and microeconomic systems, there is a science beyond the dollar amount, asset value, or expense that characterize every single financial interaction: the psychology of money. The psychology of money regards the human side of economics: all the emotions, logical puzzles, and circumstances that drive us to any decision. Despite not being a major study or focus of economics, this innate human behavior is essential to understand how easily economies can shift.
Take the example of a stock. Say there’s a stock that generally most people believe is undervalued. If these same people see that this stock passed a solid financial report and beat expectations, most people will then be driven to make a purchase into that stock, assuming it will go up. The opposite also may occur. If a particular stock is in hot-water, people will be more inclined to sell out of fear, therefore driving the stock down by some margin. This is one of the most basic examples of psychological influence on economics, and how such small instances of human intention can shift the market instantly. Decision making is extremely relevant to not only stock, but the larger scale of economics. Political action, which almost directly drives economics, is controlled by human decision. Nevertheless, it’s important we understand how human decision can change economic circumstances before we explore further economic theory deeply.
Prospect Theory
Prospect theory, pioneered by influential behavioral economists in the 80s and 90s, is one of the key ideas of the many behavioral economic concepts – which we will cover soon. The idea of placing greater weight on possible gain than possible loss is the core principle of prospect theory. The natural human reaction in situations is to place a greater emphasis on the nature of the option described in the proposition, despite both options having very similar likelihood of occuring.
Imagine your friend challenges you to flip a coin on two different days. On the first day he says, “I’ll give you $5 if this coin lands on heads, but you have to return the favor otherwise.” Enticed by his offer, you accept the deal, but the coin lands on tails – you reluctantly hand him a $5 bill. The next time, he says “if this coin lands on tails, you have to give me $5.” More hesitant about the possible loss, you decline his offer, and annoyingly watch him flip tails.
We can see that in the first example where you were enticed with a possible gain, you preferred taking the fifty-fifty chance over skimping out on the possible loss. On the other hand, we can see that when the same situation is portrayed as a possible loss, you are more hesitant – hence, creating an alternate name for prospect theory in “loss-aversion theory”. When people are prompted to use prospect theory, we see them enter two different frames of mind. The first frame is identifying all possible outcomes and determining how desirable they are. Next, they will determine which decision is best suited for them, with such previous biases of probability and desirability fresh in mind. The problem with this is that people tend to disregard unlikely events, and therefore inflate the likelihood of the option they believe will take course. Although this idea is extremely common in everyday scenarios, we can see its applications across economics, investing, and general finance as well.
In a similar scenario. If someone tells you to invest in an index fund that has an average yearly return of 15% above the market, you will likely be inclined to invest in this fund. However, if that same fund is portrayed as a fund with above-average returns but a decline over the last five years, you are less likely to invest into this fund.
Well, this should make a lot of sense, but what value does this hold? How can we use this concept to better understand financial and microeconomic applications of psychology? First of all, seeing as investors are naturally unaware of biases like this, we can see many investors make overly emotional decisions rather than decisions based on objective valuation. Perception of inherent risks in purchasing assets, for example, shifts significantly, and many people fall victim to these financial theories because of unawareness. These cognitive biases that drive emotions, and therefore our financial decisions, are key to microeconomics on the individual scale. As people make continued decisions muddled by some degree – whether it be small because of psychological awareness or large because of the latter – of bias, financial markets, supply and demand, and even political policy are eventually influenced by prospect theory. Similar to prospect theory, there is another behavioral-economic idea that ties in to existing biases: confirmation bias and selective perception.
Confirmation Bias
Confirmation bias refers to exactly what its name implies: having a bias when understanding new topics based on what is already known. Let’s look at an example of something that we are already familiar with. Imagine that a person believes that left-handed people are generally more creative than right-handed people. If that same person encounters someone who is both left-handed and creative, they are much more likely to attribute left-handedness and creativity as an association, even though this association does not exist at all.
But what about this example makes it confirmation bias? We see that this imaginary person already has a pre-existing belief that left-handedness and creativity go hand in hand, so when they see an example of such a combination existing, they have more belief in this association. Even though their original assumption was not based on real evidence, but rather an speculation, we see that an example of “evidence” supporting their belief deepens what they already believe.
Even if this is true, how do we see this play effect in relation to money and economics? One, we can see investors become overconfident in their investments. When making a decision about making an investment or not, investors may solely rely on information that supports their existing mindset, and not consider ideas that may challenge their current sentiment. This causes a deeper rooted problem, known as availability heuristic.
Imagine you are watching the news, and see a broadcast on the news about forest restorations in Canada. This information is fresh in your mind, and is ready for quick recall. Understanding that the news provides information about what happens in the world, when someone asks you what’s going on across the world, you are more likely to mention forest restoration in Canada. But why is this bad? We have to remember that although the news communicates worldly information, it is still an intermediary, and cannot be fully relied on to understand the full scope. What if the news channel you were watching was corrupt? What if the reporter misconstrued some information? The point is, even though you are quick to use your best available information regarding the news of the world, your intermediate source might not be completely accurate.
This can also be applied to smaller scenarios. Imagine that someone tells you a particular stock is very undervalued. You take their word for it. Then someone else asks you if you know any undervalued stocks; thinking you are accurate, you say the stock your friend mentioned without doing any previous research on it. To your surprise, the stock is overvalued! Your reliance on the quickest, most available information led to you to a fast assumption, but an assumption incorrect nonetheless.
In examples such as confirmation bias and availability heuristic, we see confident emotion take over investment decisions. It is the most logical course of action to reduce overconfidence as much as possible, but in doing so, not activate other artificial filters in decision making. We often also see other compulses consume investors alike.
Fear and Greed
Like overconfidence, fear and greed in investing often ruins investing decisions for many investors. They are both key parts of consumer sentiment, and have very large effects on financial markets. In its essence, greed and fear is the idea that investors may invest because they don’t want to miss out on the possibility of high returns, or they might sell an asset prematurely to avoid potential losses. Let’s look at how each of these affect us emotionally. Pretend I invested in a stock, and over the course of the last month, it grew 15%. Impressed by the current growth, I continually imagine what the next months’ growth will entail, and I eventually decide to buy back into the stock without consulting any data. Consumed by my greed, I watch the stock price fall back down to 5% below the value I bought it at.
We can see a similar phenomena occur from fear. Let’s pretend that the same stock went down 5% and then 3% in two months instead of growing 15%. Concerned that the stock price will barrel down further, I sell the stock, and watch it rise back again. Sucks right? This shows how emotional appeals in investing can harm future returns.
On the surface, fear and greed may seem to be unquantifiable, emotional factors. However, there is in fact an index that can measure how much investor sentiment in fear and greed affects a market. This index was developed by CNN Businessmen to provide insight on how fair a stock price is at a given time. Within this index, there are seven factors that influence the index’s value: stock price momentum, stock price strength, stock price breadth, put and call options, junk bond demand, market volatility, and safe-haven demand. Let’s quickly break the most important ones down so we can understand how certain greed and fear indices can arise. Stock price momentum refers to the momentum, per se, of the entire market – or how sustainable a market is in its current trend. This index is calculated by measuring the S&P 500 – an index stock of the 500 largest US companies – versus its moving average, a way to measure stock security. Stock price strength is the number of stocks hitting a 52-week high in the S&P 500 over the number of stocks hitting a 52-week low. Lastly, put and call options are compared to see which of those has higher trade volume, where puts lagging behind calls signifies greed, and vice versa indicates fear.
We can ultimately see this index somewhat accurately analyze real market events and provide insight on how a market is functioning at a given time period. Based on the CNN’s score to sentiment chart, scores ranging from 0 to 45 reveal a sentiment of market fear, 45 to 55 is neutral, and 55 to 100 demonstrate greed. During the S&P 500’s 2008 crash, we see that its index sank to 12, while during the quantitative easing of 2012, the score rose to 90. Similarly, we see that during the start of the COVID pandemic in 2020, the index dropped all the way to 2, and rose up to 75 when optimism about the pandemic grew.
Beyond quantifiable measures of fear and greed, we can see that other people can influence our investing decisions during high emotional times very strongly. In times of fear, we are more likely to take influence from other people, muddling our own judgment and significantly changing our own sentiments. This influence can take the form of observing others’ actions or willingly taking direct advice from them. We can see a similar process occur under greed rather than fear. Many investors will toil with resisting the impulse to sell on a profit; they seek delayed gratification, but value the actions of others highly when determining ideal times to maintain holdings, or sell. Although having a plausible positive outcome, many investors struggle to identify optimal solutions to investing problems while they are consumed by emotion.
