Bulls’ Psychology In A Bear Market

20 September, 2011, 13:38. Posted by Zarathustra
Tags: Bear, Bull, Market, Psychology

Daniel Kahneman, a professor of psychology who somehow got the Nobel prize in Economics for his rubbishing of some of the assumptions in economics, wrote his paper on the so-called “prospect theory”. In developing his prospect theory, he has done some experiments to examine how people make decision in uncertain or risky situations.

One of the problems they asked their human participants to solve involve something like this:

You are given two choices.
A. You are offered $1,000 with 100% certainty;
B. An equal chance of winning $2,000 or winning nothing.
What would you choose?

In the second problem, you are given the following two choice

C. You will lose $1,000 with 100% certainty;
D. An equal chance of losing $2,000 or losing $0.
What would you choose?

In the first case, the expected pay-off for both choices are $1,000. In the second case, the expected pay-off are both –$1,000. To put it very simply, if people are rational, people should be indifferent to choices A and B in the first case, and choices C and D in the second case. Of course we know humans are not rational.

In reality, people preferred the certain outcome in the first problem, that is they would prefer A over B. In the second problem though, people actually prefer D over C.

The second problem illustrate that people hate to lose. One can call it loss aversion. The curious implication here is that when present with choices which has risks to the downside, human being is actually risk seeking.

In the past month or two of market turmoil and extremely volatility, bullish folks have probably been buying equities all the way down. They are now facing a situation someone similar to the second problem (i.e. choosing between C and D). If they get out of the market now, they will surely lose money. But if they hold on or even increase their market exposure, they are facing something similar to D, which is either they lose even more, or they are able to recoup the losses.

Of course, human psychology in market is much more complex that a binary option between C and D. In reality, not only the probability of each possible scenario is uncertain, the number of possible scenarios can be infinite as well.

And perhaps the bulls can be right, who knows! Perhaps it is really time to be greedy when you think everyone else is fearful. Here, however, I am not convinced.

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