The Psychology of Stocks It has been a bumpy ride on Wall Street this week. Could psychological theories help explain what is happening on the trading floor? Investment strategist Michael Mauboussin, author of More Than You Know: Finding Financial Wisdom in Unconventional Places, discusses the science of stocks.

The Psychology of Stocks

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You're listening to TALK OF THE NATION: SCIENCE FRIDAY. I'm Ira Flatow.

And for the rest of the hour, the headlines have been awashed with stock market stories lately as the Dow Jones continues its wild ride. Phrases like sub-prime loans, credit crisis have been tossed around to explain Wall Street woes. But if you listen very closely, you may hear the mention of herd mentality, or Zimbardo psychology experiments. That's because some economists believe scientific principles, once discovered in psychology, sociology, even ecology labs, can be used to understand the movement of the markets.

And here to talk to us about the science behind the stocks is Michael Mauboussin, he is adjunct professor, business professor at Columbia University as well as chief investment strategist at Legg Mason, a global asset management company. He wrote a book called "More Than You Know: Finding Financial Wisdom in Unconventional Places" published by Columbia University Press. And one of those places he discusses is the science lab. He joins us today from Hawaii. Welcome to the program, Mr. Mauboussin.

Prof. MICHAEL MAUBOUSSIN (Chief Investment Strategist, Legg Mason Capital Management; Author, "More Than You Know: Finding Financial Wisdom in Unconventional Places"): Thank you, Ira. It's great to be here.

FLATOW: How would you describe this market?

Prof. MAUBOUSSIN: Well, I think it's - we go through these tumultuous periods episodically, once every few years. The market today, I think, it feels is challenging for many people as we saw in 1998, which is on the heels of long-term capital management, and I heard a comparison this morning to an environment as challenging as 1987, which was, of course, the huge crash of '87 in October. So a very, very difficult market for a lot of participants.

FLATOW: Mm-hmm. Sometimes, it seems to have like a - it's an organic animal of its own, you know? It seems to have a mind of its own going in place.

Prof. MAUBOUSSIN: I think that metaphor is not bad one. You can think about market, big market moves, sort of, on two levels. One would be sort of exogenous shocks happening to the market. These would be things like, you know, Hurricane Katrina, or the president being assassinated, or 9/11. And the second wave, thinking about it, would be much more endogenous, things that are internal to the system, sort of the workings of the system create these instabilities in these large-scale moves. And I think the latter is much more interesting and much more indicative of the kinds of things you were talking about at the opening with psychology and herding.

So, no question, we get these from time to time. People always wonder whether we can eradicate these kinds of big moves, but unfortunately, they're all rooted in human psychology, until we change how humans think and behave, it's very unlikely we'll be able top change these kinds of events.

FLATOW: Is it then really herd mentality that, you know, you hear rumors, you know, we like to think that the market is based on sound economic principles. You're talking more like it sounds like it's based on sociology more.

Prof. MAUBOUSSIN: So, I was - I'd take one big step back and say, how does finance folks or economists typically represent how markets get to efficiency? And by the way, efficiency itself is a term that comes from physics, right?

FLATOW: Mm-hmm

Prof. MAUBOUSSIN: Is that the prices reflect the fundamentals. The classical way to get there is through rational agents, that you and I understand how to trade off risk and reward, and we price assets appropriately. In fact, vast majority in models that are used in economics and finance to represent markets are based on this notion of rationality.

There's another way to get there, which I think is much more interesting, which would be thinking about markets as a complex adaptive system. The hub of this research, as you know, for the last 20 or 25 years, has been the Santa Fe Institute. Recently, people have been talking much more colloquially about this in terms of wisdom of crowds. What I like about this mindset is that it requires certain conditions to prevail for the system to work. And for wisdom of crowds or complex adaptive systems to function well, you need three conditions in particular.

The first is you need underlying agent diversity. So, for our world, of course, those agents would be investors, long term-oriented, short-term, technical, fundamental, what have you. They could also be, in other systems, ants in an ant colony, they could be neurons in your brain, all sorts of examples of those agents.

The second thing we need is some sort of aggregation mechanism. Some way to bring the information together into one place. In markets, of course, those are exchanges, but there are other mechanisms at work as well. And the third thing we need are incentives. Some way to reward people for being right and penalize them for being wrong. Of course, in financial markets, those are financial rewards, money, but they need not be. They could be reputational, it could be fitness for a species.

So when those conditions prevail, you tend to get good results, kind of fundamentals reflected in prices pretty accurately. But when more and more of those conditions is violated, we tend to get very inefficient markets and I think what we're seeing, and by far, the most likely to be violated is diversity, and I think we're seeing a classic example today of what I would call diversity breakdown, where people are starting to mimic one another to the detriment of market performance.

FLATOW: It's like - they're like the lemmings, they're all watching what the other person is doing.

Prof. MAUBOUSSIN: Exactly. And you brought this up - you mentioned the Zimbardo experiment, the Stanford Prison Experiment, and there's another famous experiment I often like to invoke, which is the Solomon Asch experiment on social conformity. And what that showed through experiments in the '40s and '50s, and by the way, these have been replicated recently in labs, so there's nothing about, you know, the history that's unique. It says, if you put people in a contrive situation and they will often - with a high percentage of probability - imitate the behaviors of others, especially if that situation has some ambiguity in it.

So we as humans are natural imitators. Often, there's enough diversity in the markets to keep markets relatively stable. But periodically, we do get that runaway effect where the positive feedback takes over and we get these extremes, both on the euphoric side, which we saw in late 1990s and early 2000s with the Internet stocks, and then now much more in the depressed side we see, for example, some parts of the bond market.

FLATOW: Mm-hmm. 1-800-989-8255 is our number, talking about the psychology of the stock market.

But then, if we're talking about the stock market as a social or an animal or some sort of social being, they have leaders. I mean, societies have leaders, and they have diseases and things like that. Could you - are those things mimic the social movement of the stock market?

Prof. MAUBOUSSIN: What's interesting to me is in these complex adaptive systems, maze complex adaptive systems, the systems operate quite robustly without any leadership. And I think this is one of things that's very difficult for humans to internalize. So, for example, if you do study swarms, or colonies of bees, or colonies of ants, as we know, there are no leaders. There - the system emerges from simple rules that each of the individual agents follow. Now, of course, in our world, there would be leaders or there would be certainly institutions that have more sway than others.

For instance, today, one example would be the Federal Reserve, right? So the United States - in fact, the United States government, the Federal Reserve, today took some actions to try to calm down the markets, indicating that it was going to - that it would make capital a little bit more accessible. And also, I think trying to use some of its moral suasion to get people to settle down a little bit and say that they would act as a backstop. So there is a dimension where there can be, in some lose sense, leaders. But what I want to emphasize is in these types of systems, markets included, you need not have leaders for the system to function both well, and for the system to periodically break down.

FLATOW: And what about diseases? Could, you know - who starts this rounds? You know, somebody starts rumoring, right? Isn't it how these things start? There's a fact here, there's a rumor there? I'm thinking of that great - I'm thinking of that great scene from "Trading Places" on the orange juice future's were, you know?

Prof. MAUBOUSSIN: Right. Well, I do think the models from epidemiology are very useful in thinking through this. And one of things that we do also know from these types of system - this could be diffusion of anything, diffusion of ideas, diffusion of innovations - is that there tends to be a so-called tipping point. So, for example, if you think about disease, you need to have both some degree of interaction between the different agents, or people in this case, and you need to have a fairly contagious disease. And when those two things combine, enough people are exposed, the thing will take off, and grow in a nonlinear fashion.

What we also know in these complex systems is that, the magnitude of perturbation and the outcome are not necessarily proportionate. So we're used to like seeing, you now, long - large perturbation leading to large scale outcomes, small perturbation, small outcomes. But in these complex systems, there's an inherent degree of non-predictability. So even a small perturbation could lead to large-scale outcome, and the inverse being true. So we have to think about these things probabilistically.

Now, almost every time you see some sort of major problem in markets - in 1987, the Internet in 1990's, and certainly today, there's almost always a kernel of something that's legitimately an issue. So, for example, I think the kernel we would point to in this current environment would have what had happened with the sustained low interest rates, which really encouraged the housing -depletion in the housing prices, which incurred some less than optimal behaviors in the sub-prime lending market, which led to some of the cascading effects we saw today.

So there's almost always something there. But what's important is, we also have to think about the counterfactuals, which is, what could have happened. And we don't always know what could have happened. So we may have averted disasters in the in the past narrowly. And sometimes, things that are relatively small have a much bigger impact than we might perceive otherwise.

FLATOW: 1-800-989-8255 is our number. We're talking with Michael Mauboussin of Legg Mason.

Let's go to the phones to Robert(ph) in Berkeley. Hi, Robert.

ROBERT (Caller): Good morning. I've just retired from 22 years as a financial planner with a background in things like neuroeconomis and physiology, and I respectfully disagree. It's not us that are causing this. If you figured there are a billion and a half shares traded today, you and I and regular people, we'd sell 100 shares of that stock, that's a big thing. It's really the Harvard Fund or Ford's Pension Plan that are - or the - and the hedge funds that are all computer generated, are doing lending-like behavior, you know, we might sell 100 shares. We, people, aren't doing this.

Prof. MAUBOUSSIN: Yeah, Robert, I don't disagree with that. I mean, I think your observation is correct. I mean, it's important - I give this - you know, I mentioned something like ant colony where you might feel each of the ants would have a similar voice. But of course in markets that would not be the case, that our voices would be amplified by the amount of the capital that we're using. So you're absolutely correct. I think the basic mechanisms would still be the proper mechanisms to think about.

So for example, you mentioned some of these quantitative strategies. What was going on were a lot of big funds were driven off computer programs. Those computers looking for, of course, anomalies and hence mispricings in the market. And what's happening is that, many of the same programs were following the same types of strategies, and hence, putting on many of the same types of positions. The very fact that a lot people are doing the same thing means that the profits get windowed away. And then when things turn bad, especially if they use leverage, they need to - they all start behaving in unison.

So I think the basic idea is the same. But you're right. I mean, it's going to be much more - it's going to have much greater impact if you're talking about the large institutions rather than you and I as individuals in how we affect markets. I would say, though, however, typically, individuals do follow the bigger trend. So we can track individuals and we can show that individuals tend to do poorly over time because of market timing. I'll just give you…

ROBERT: Yes, they do. Yeah, individuals do horribly (unintelligible) all the time.

Prof. MAUBOUSSIN: Right. And this - so they're followers, and you're right, so their followers. So one statistic I like to mention is, you know - these are from Jack Bogle - that over the last 20 years, the markets been up a shade over 11 percent annually. The average mutual fund is up less than 10 percent. And the difference there, we can explain primarily via fees. But the average individual has earned less than seven percent, so a far cry from the market itself primarily because of bad timing. So whereas they may not be the precipitators of this, they certainly are the fast followers to their own detriment.

FLATOW: Thank you, Robert.

Our number, 1-800-989-8255, talking with Michael Mauboussin, who's adjunct professor - a business professor in Columbia, as well as a chief investment strategist at Legg Mason, author of "More Than You Know: Finding Financial Wisdom in Unconventional Places" on TALK OF THE NATION: SCIENCE FRIDAY from NPR News.

I'm Ira Flatow, talking about - he raised an interesting point, the caller did, about these computer-generated buying and selling programs. Do they basically run the market with the huge amounts of volume they can generate?

Prof. MAUBOUSSIN: Yeah. I think it's difficult to say any one group or constituency runs the market, but certainly their influence has grown. And as you point out, what they tend to do is, comb lots of data to try to find relationships that are, you know, mispriced, and then put on trades to try to take advantage of those mispricings. And again, the challenge would be, if we have a lot of really smart people doing a lot of the same thing, running very similar types of algorithms, then those trades become very crowded.

I think one of the examples that we saw - these pronounced examples that we now can understand from a physiological perspective - was what happened in 1998 with long-term capital management. Clearly run by very bright people and very capable people, looking for a lot of statistical arbitrage opportunities. But once the word got out that they were putting on a particular trade, some sort of relationship they were betting on, others in the financial community started making the same bets. And when they used those bets with leverage, all goes well until it doesn't. And when those trades start to turn the other direction, and also because of other mechanisms like collateral requirements in the financial community, what turned - what started off is a very good thing can turn into a very bad thing very quickly. So I think that that certainly has played a material role certainly in the last couple of weeks for what we've seen in the stock market.

FLATOW: You know, there's an old phrase on Wall Street that, money is made when there's blood in the water. And there's certainly blood in the water now. In other words, times are bad. Who are the people, and these models, who can sit there and say, you know, I'm going to wait, I'm going wait, and now it's low, I'm going to buy?

Prof. MAUBOUSSIN: Great question. Part of the answer to that, or the main part of the answer to that would probably be a function of your time horizon. So if anybody said, will the markets be up or down in the next three days or three weeks or three months, I think that will be a very difficult call. But if you, on the other hand, say, I'm going to take a longer-term perspective and think about three years, I think it's a much more a straightforward call.

There had been investors over time that had been very effective at this. I mean, certainly the one you'd have to hold out would be Warren Buffet, who's talked a lot about - almost, you know, rephrasing what you said. He said, we would like to be fearful when others are greedy, and greedy when others are fearful. Clearly, we were - we saw a lot of people being greedy in the late 1990s and early 2000s. And Buffet himself was hunkered down at that point. And now, you're certainly seeing a lot of people that are fearful, so he would probably take the other side on a lot of these trades. So, part of the answer on that is a function of time horizon, but my suspicion is, if you would take a longer term perspective, it's a good time to participate.

Now, I do want to emphasize two things on that. One is, it is psychologically very difficult to go against the crowd. And we know that again from social psychology. There's a lot of advantage conferred to people being part of the crowd from an evolutionary perspective. So psychologically, it's very difficult to do. And the second is, for many professional money managers, there are a lot of institutional constraints. So a lot of money management organizations may impose constraints on individual portfolios or portfolio managers that impede their ability to do that. So, I would just say, clearing one of those hurdles, either psychological or institution, is difficult. Clearing both for many professional money managers is nearly insurmountable. So it's very difficult to do.

FLATOW: That's why it's so hard to buy low and sell high.

Mr. MAUBOUSSIN: Exactly.

FLATOW: All right. Thank you very much, Michael, for taking time to be with us.

Mr. MAUBOUSSIN: My pleasure.

FLATOW: Michael Mauboussin, author of "More Than You Know: Finding Financial Wisdom in Unconventional Places." He's a chief investment strategist at Legg Mason Capital Management and adjunct professor at Columbia Business School in New York.

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