The late psychologist Daniel Kahneman had an important message for investors, analysts, and economists: Be careful when you treat the market as if it were a person.
Kahneman, who passed away this past March, was a Nobel laureate in economics. He received the accolade in 2002. That year, he also gave a presentation at Northwestern University, and discussed investorsā tendency to personify the market. Because this particular message appears to have gotten lost among his many other pronouncements, and as a tribute to his legacy, I reproduce portions of his 2002 presentation below.1 For sake of clarity, I have divided excerpts into sections with headings, and added occasional commentary of my own (headed āShort Comments).
Kahneman: Does The Market Have A Psychology?
This talk is meant to be about Psychology and the Market.
If you listen to financial analysts on the radio or on TV, you quickly learn that the market has a psychology. Indeed, it has a character. It has thoughts, beliefs, moods and sometimes stormy emotions.
The main characteristic of the market is extreme nervousness. It is full of hope one moment and full of anxiety the next day. It often seems to be afraid of economic good news, which make it worry about inflation, but soothing words from the chair of the Fed make it feel better.
The market is swayed by powerful emotions of like and dislike. For a while it likes one sector of the economy, but then it may become discouraged, suspicious, and even hostile.
The market is generally quite active, but occasionally it stops to take a breather. And sometimes it catches its breath and takes profits. In short, the market closely resembles a stereotypical individual investor. Because it is very high-strung and insecure, I think it is Jewish.
Kahneman: What Accounts For The Tendency To View The Market As A Person?
The tendency to ascribe states of mind to entities that donāt have a mind is a characteristic of an early phase of cognitive development, as when a child says that the sun sets because it is tired and going to bed. And we can recognize it in ourselves as grown ups: when I play snakes and ladders, it is sometimes hard to avoid the impression that this green object is full of energy, whereas the yellow one is a bumbling mess that will never get anywhere.
Why do adults engage in this kind of animistic thinking about the market? What does it do for them? I am arguing, of course, that this thinking happens automatically. But it also has a function, as a way of making sense of the past, which creates an illusion of intentionality and continuity. I am using intentionality here as philosophers do, to denote beliefs as well as desires.
The personification fosters an illusion of predictability. The point is that intentional interpretations of behavior generate expectations of future behavior. And it is a psychological fact that the tendency to produce such expectations will persist indefinitely, even if they are reinforced on a strictly random schedule.
Short Comment 1
About a decade after Kahnemanās Northwestern University presentation, he told me that he remembered the event fondly, especially the first excerpt above. As for the second excerpt, it relates to a general theme he emphasized for years, the illusion of predictability. Readers of his best seller Thinking, Fast and Slow need only search the index for the phrase āfinancial advisers and forecastersā to locate the relevant passages.
The next excerpt describes how the issue of personification applies to the thought processes of economists, who make widespread use of models involving what is called a ārepresentative agent.ā You can think of a representative agent as being average, and a representative agent model as a framework which explains events as if all agents are average. Representative agent models are important and are often the basis for major macroeconomic policy recommendations.
Kahneman: Does The Theoretical End Justify The Theoretical Means?
Analysts are not the only ones who think of the market as a person. People who write models with representative agents obviously do something of the same general kind. Some of my best friends have written such models.
As a psychologist I have always liked these models, especially when they are written in a language I understand.
But this is an instance in which my friends do something that they oppose and even ridicule in other contexts. They make assumptions that they know are not true, just because these assumptions help them reach conclusions that make sense.
In fact, of course, agents are not all alike and the differences among them surely matter.
Realism will be improved by having two types of agents, with different psychological makeups.
Short Comment 2
I found Kahnemanās remarks in 2002 about representative agent models to be striking. This was because around 1990, I had begun to study models in which agents are not all alike. Around 1996, my work focused on whether there are sensible conditions which would justify economistsā representative agent assumption. The answer turned out to be mixed, having the form of āyes, but.ā Yes, there is a representative agent, but its characteristics are generally very different from the individual agents in the market. By difference, I mean that the representative agent changes its mind more frequently than individuals. He (or she) is more erratic in updating probabilistic information, and has a more volatile appetite for risk-bearing than most individuals.
The next excerpt mentions Terry Odean, Brad Barber, and Burton Malkiel. All three are financial economists. Odean and Barber are well known for their work on the behavior of individual investors. Malkiel is well known for having the authored the best seller A Random Walk Down Wall Street.
The excerpt also mentions a phenomenon called āthe disposition effect.ā This phrase is short hand for the disposition to sell winners too early and hold losers too long. In 1985, my colleague Meir Statman and I introduced the concept into the literature.
Kahneman: How Do Institutional Investors and Individual Investors Compare?
If I have time, I will speculate in a completely irresponsible fashion about possible similarities and differences between individual and institutional investors
We know from Terry Odeanās famous result that individual investors pay about 3.4% plus transaction costs whenever they have a significant idea about changing their portfolio. It seems plausible that there is someone on the other side of these transactions, and likely that these are institutions.
Terry and Brad have begun to investigate some plausible hypotheses about differences in the trading behavior of individuals and institutions.
They seem able to do very well without any real inspiration from psychology, but I think that an effort to find out which psychological principles that describe representative individuals also apply to representative institutional investors, is very worthwhile.
I should report on preliminary results from research I undertook by taking Burt Malkiel to lunch. He actually does not believe that institutions are smarter than individuals. But this may not be the last word. For example, Burt could not answer my question about whether the disposition effect also applies to institutions.
Short Comment and Conclusion
I can shed some light on the last sentence of this excerpt. When Meir and I published our paper on the disposition effect, we focused mostly on individual investors, but provided some evidence suggesting that institutional investors had learned techniques to avoid holding onto losers too long. Subsequent studies indicated that by and large, institutional investors exhibit similar disposition behavior patterns as individuals, but perhaps to a lesser degree.
In his long career, Kahneman left much for us to ponder about financial vulnerabilities. The need for care when personifying the market is a case in point. He wanted us to realize that individual investors, institutional investors, analysts, and economists are all prone to the illusion of predictability.