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Emotion, Not Rational Logic, Determines the Stock Market

Stock market activity dictated by emotions of traders and investors

If you believe the advise of the thousands of financial advisors and gurus and media shows, giving analysis and advice, you would think that stock market activity is rational, logical and analytical. Not so according to recent research in the field of behavioral economics and psychotherapy, which points to the predominant influence of emotions.

In recent years, scientists have begun to suspect that emotion plays an important role in evaluating risk and making decisions. We are told that stock traders are trained to evaluate risk and information quickly and reliably, and they often have large financial incentives riding on their decisions--which should cut down on bouts of non-rational behavior. Even so, earlier studies have suggested that many successful traders base their trades on intuition and feelings.

These studies use what is termed Human Emotion theory (HUEMO) as it applies stock market. The theory flies in the face of traditional stock analysis techniques, which rely on technical and fundamental valuations to determine the optimal price levels for specific stocks. Traditional stock market theories rely on the assumption that stock traders make decisions in a completely rational and objective manner, while taking time to synthesize all available information. The core of HUEMO theory is the realization that this assumption is unreliable in the real world.

Stock traders make decisions based on psychological factors, including emotions, and may place undue weight on specific information at the expense of other relevant data. Different emotional states can have unpredictable effects on decision-making at different times. Mood can have an impact on cognitive performance and expectations, while factors such as a series of gains or losses can have an effect on traders

Researchers, Andrew Lo, a finance professor at the Massachusetts Institute of Technology, and Dmitry Repin, a neuroscientist at Boston University, now at MIT  monitored physiological indicators of emotional state in financial securities traders at work in real-time market trading. Their results, published in the Journal of Cognitive Neuroscience suggests that emotion may influence many if not all of Wall Street traders’ decisions.

To determine whether emotion plays a role in traders' intuition, they monitored the heart rate, blood pressure, and skin conductance of 10 professional traders during the course of a normal day. They also collected real-time financial information, recording the prices and trends of the 13 foreign currencies and two stock futures that the traders were eyeing and manipulating. The researchers evaluated the physiological responses to three general types of events: trends, in which stock prices march steadily in one direction; trend reversals; and volatility events, in which prices fluctuate all over the map.

The results? Even veteran traders with a reputation for logical cold decisions had heart palpitations during volatile events, and less experienced traders reacted emotionally to a broader swath of market behavior, Lo and Repin reported.

Investors get carried away with excitement and wishful ‘phantasies’ as the stock market soars, suppressing negative emotions which would otherwise warn them of the high risk of what they are doing, according to a study led by the University College, London, U.K. published in the International Journal of Psychoanalysis Economic models fail to factor in the emotions and unconscious mental life that drive human behavior in conditions where the future is uncertain says the study, which argues that banks and financial institutions should be as wary of ‘emotional inflation’ as they are fiscal inflation.

According to these studies, the market is dominated by rational and intelligent professionals, but the most attractive investments involve guesses about an uncertain future and uncertainty creates feelings. When there are exciting new investments whose outcome is unsure, the most professional investors can get caught up in the ‘everybody else is doing it, so should I’ wave which leads first to underestimating, and then after panic and the burst of a bubble, to overestimating the risks of an investment.

Regret and pride guide stock investors more than economic facts—often to their financial detriment—according to a study published in the Journal of Marketing Research by Brad Barber, a professor in the Graduate School of Management at the University of California, Davis. Barber analyzed trading records for 66,465 U.S. households with accounts at a large discount broker between January 1991 and November 1996 and another 596,314 U.S. investors with accounts at a large retail broker between January 1997 and June 1999.

“Having sold a stock, investors are disappointed if it continues to rise, and regret having sold it in the first place,”  Barber says. “They anticipate that their disappointment and regret will be more intense if they repurchase such a stock rather than not repurchasing it; thus investors are most likely to repurchase a stock previously sold for a gain that is trading below the price at which they sold it.”

The analysis suggests investors often make decisions based on emotions such as regret, disappointment, pride and contentment. All behaviors were consistent with what the researchers term “counterfactual thinking”—looking back at what could have been—and suggest that investors are motivated by a desire to avoid regret and instead feel pride.

So it seems the swings in the stock market may be more a result of emotional reactions, not rational, logical thinking on the part of traders and investors. So much for the science of stock trading and investment.

Ray Williams is the author of Breaking Bad Habits and The Leadership Edge.

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