Market Insanity

Perspectives in Behavioral Economics and the Economics of Behavior Series Editor Morris Altman Market Insanity A Brief Guide to Diagnosing the Madness in the Stock Market Michael Taillard Market Insanity This page intentionally left blank Perspectives in Behavioral Economics and the Economics of Behavior Market Insanity A Brief Guide to Diagnosing the Madness in the Stock Market Michael Taillard Series Editor Morris Altman Academic Press is an imprint of Elsevier 125 London Wall, London EC2Y 5AS, United Kingdom 525 B Street, Suite 1800, San Diego, CA 92101-4495, United States 50 Hampshire Street, 5th Floor, Cambridge, MA 02139, United States The Boulevard, Langford Lane, Kidlington, Oxford OX5 1GB, United Kingdom Copyright © 2018 Elsevier Inc. All rights reserved. No part of this publication may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording, or any information storage and retrieval system, without permission in writing from the publisher. Details on how to seek permission, further information about the Publisher’s permissions policies and our arrangements with organizations such as the Copyright Clearance Center and the Copyright Licensing Agency, can be found at our website: www.elsevier.com/permissions. This book and the individual contributions contained in it are protected under copyright by the Publisher (other than as may be noted herein). Notices Knowledge and best practice in this field are constantly changing. As new research and experience broaden our understanding, changes in research methods, professional practices, or medical treatment may become necessary. Practitioners and researchers must always rely on their own experience and knowledge in evaluating and using any information, methods, compounds, or experiments described herein. In using such information or methods they should be mindful of their own safety and the safety of others, including parties for whom they have a professional responsibility. To the fullest extent of the law, neither the Publisher nor the authors, contributors, or editors, assume any liability for any injury and/or damage to persons or property as a matter of products liability, negligence or otherwise, or from any use or operation of any methods, products, instructions, or ideas contained in the material herein. Library of Congress Cataloging-in-Publication Data AcatalogrecordforthisbookisavailablefromtheLibraryofCongress British Library Cataloguing-in-Publication Data AcataloguerecordforthisbookisavailablefromtheBritishLibrary ISBN: 978-0-12-813115-2 For information on all Academic Press publications visit our website at https://www.elsevier.com/books-and-journals Publisher: Candice Janco Acquisition Editor: Graham Nisbet Editorial Project Manager: Susan Ikeda Production Project Manager: Joy Christel Neumarin Honest Thangiah Designer: Mark Rogers Typeset by VTeX Dedication An Open Letter to Accounting and Financial Professionals: Your field provides amorereliableanddetailedrecordofhumanhistorythananyother.Itisa profession of creating and using records that, by necessity, must be free of em- bellishment or interpretation in order to be functional. There is no revisionism declared by a class of ruling or conquering leaders. There is no morality-based controversy by which people of a faith might feel the need to alter a reality, no matter how obscure or private. There is only the need for accuracy in recording and maintaining information about resources and the transactions of those resources which occur. It is a quantitative field of measurement, devised from its inception to prevent misinterpretation or the intervention by shysters. The invention of the written language did more to shape human development and the ability of societies to function than just about anything you can think of, and was critical to the development of fundamental mathematics. Without the invention of the written language, modern society would fail to develop even in its most fundamental forms, and this invention owes its existence entirely to the fields of accounting and finance. The first language, known as Cuneiform, was developed for the purpose of recording business transactions, using small clay tablets as receipts, inventory records, and other matters of daily financial operations. These were so important, that they also inspired the first envelopes, in which these clay receipts were placed inside thin hollow clay shells that were only broken upon completion of the transaction, so that there was no question about counterfeiting the contents of the records. Consider how much data you handle and store at any given time for your company or clients. How long do you maintain those archives before they are purged? Maybe you keep records for 15 years? At most, you might keep them for 20 years? It is almost certain, as it is among the majority of people, that the oldest records in your archives are less than 10 years old. Now consider the age of your company – the year it was formed. Now each of these ancient remnants is considered priceless as a source of knowledge about our own origins and history – a true history of humanity, which tells a real story that transcends the machinations of those who try to define history, yet around the world, exhibits of ancient currency and trade such as at the Detroit Institute of the Arts are left abandoned, with the last expert on their exhibit retiring many years ago without areplacement. v vi Dedication Coming back to the modern day, how old is the company for which you work? How much history has been lost while purging the archives of old financial records? What value would these records have had as data to modern researchers working to understand the mechanics of the world around us and im- prove upon the methods currently being used? What value would these records have had to future generations as they strive to better understand the people and events that led to the nature of their current civilizations? The records you purge are of great value today, and will be priceless in the future. Though you likely sort through countless volumes of data on a regular basis, most of it mundane or even useless to you in your current endeavors, remember that it is an invaluable source of understanding for others. Each record you destroy is a small piece of human history that is now forever lost. It is with this understanding that I implore you to reconsider your current protocol for destroying old records. Simply put: Stop it. Michael Taillard Contents Dedication v About the Author ix Preface xi 1. Introduction 2. The Rational Fallacy 3. Bizarre Biases 3.1 Self-Serving Bias 15 3.2 Status Quo Bias 17 3.3 Confirmation Bias 19 3.4 Statistical Bias 22 3.5 Home Bias 25 Conclusion 28 4. Bad Behavior 4.1 Herd Behavior 31 4.2 Anchoring 33 4.3 Mental Accounting 36 4.4 Nepotism 38 4.5 Satisficing 39 4.6 Rational Ignorance 43 Conclusion 44 5. Problematic Perception 5.1 Information Asymmetry 46 5.2 Endowment Effect 48 5.3 Prospect Theory 50 5.4 Disposition Effect 52 5.5 Illusory Control 55 vii viii Contents 5.6 Misperceived Risk 60 5.7 Role of Expectations 62 5.8 Frame Manipulation 63 Conclusion 66 6. Feeling Foolish 6.1 Emotional Influence 67 6.2 Gambler’s Fallacy 70 6.3 Motivational Theory 74 6.4 Psychological Reward 79 6.5 Observation Effect 83 Conclusion 86 7. Mindful Measures 7.1 Financial Abnormalities 87 7.2 Buying Happiness 96 7.3 Money, Marriage, and Family 99 Conclusion 102 Conclusion 103 Afterword 111 Bibliography 119 Index 123 About the Author Michael Taillard, PhD MBA Michael Taillard is a private economic consultant, emphasizing applied strategy and quantitative behavioral research. His other works include titles like Corpo- rate Finance for Dummies (John Wiley & Sons), and Aspirational Revolution: The Purpose-Driven Economy (Palgrave Macmillan). He has taught and created original course content for universities around the world. ix This page intentionally left blank Preface This book, oh my dear reader, is not one that contains any information that is entirely new nor entirely profound when taken individually. Having decided to read this book, it is likely that you will be familiar with at least some of the basics contained within, since it is within the nature of the topic of this book that by having decided to read it you most likely already have some interest either in economics or psychology. Rather, this is a topic currently considered to be interdisciplinary – combining elements of both into a very new area of research called behavioral economics. It is the nature of this book, then, that it utilizes the works of many modern researchers in this new branch of behavioral science to finally make some sense of what is happening in the stock market. This falls into a specific sub-discipline called behavioral finance, if you really enjoy labeling things (and who does not enjoy labeling everything into narrow categories!). The end result is a book which contains a few things you know and afewthingsyoudonottoexplainalotofrecentdiscoveriesrelatedtohuman behavior in matters of money. The way this book is written is to provide some of the basics from both psychology and economics for the sake of people who have studied only one or neither, and then applying them in new ways (but only as appropriate given the existing research) to the benefit of everyone. From the perspective of an economist, this means addressing how the mind works and the manner in which the mechanics of the brain inherently shape investing decisions, shaping the whole of global capital markets. From the perspective of a psychologist, this means looking into how the unique environments and novel measurements af- forded by economic research provides insight into the mechanics of human brain and the broader implications these have for understanding the behaviors of in- dividuals and groups. Ihopeyouenjoyreadingthisbook.Maybeyoulearnsomethingnew,and that will be great, too, but enjoyable books sell better, so let us focus on that.

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