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Keynes and the Psychology of Markets The idenTificaTion and uTilizaTion of balanced ladder levels in keynesThe T echnicaland analysisThe P ofsycholo sTock and markeGT indexy Time series of markeTs sTella osoba, cmT bioGraPhy Stella Osoba, CMT absTracT Perhaps, there can be no clearer illustration of the validity, in the real world, Keynes insights into the behavior of market participants and the irrationalities of Keynes’s enduring description of the psychology of market participants and which shapes their behavior and informs their choices in a capitalistic society proof of the validity of behavioral fnance which underpins technical analysis continues to be as relevant today as it was in the days when he frst wrote about than Chuck Prince’s statement. them. This article is an analysis of John Maynard Keynes contributions to the felds of behavioral fnance and behavioral economics, through a study of his backGround writings and an overview of his own speculating and investing behavior. Much has been written about John Maynard Keynes. He was a towering intellect of the twentieth century. Born in 1883, his father was a philosopher and an inTroducTion economist at Cambridge university, and his mother; Florence Ada Keynes was It was in Japan in July of 2007, as worldwide fears mounted over the growing the frst female councilor of Cambridge Borough Council and she became mayor problems in the US subprime mortgage market, loosening credit standards and of Cambridge in 1932. Keynes studied mathematics at Cambridge, it was there increasing signs of a housing bubble that Chuck Prince, then CEO of Citigroup that one of his tutors, Alfred Marshall who became his mentor encouraged him made a comment widely believed to be the most infamous of the fnancial crisis to turn his attention to economics. As an economist, Keynes contributions to of 2008-2009. He said, “When the music stops, in terms of liquidity, things will be the formation of British economic thought was impressive. He worked as a complicated. But as long as the music is playing, you’ve got to get up and dance. clerk in the India ofce, and wrote his frst book, “Indian Currency and Finance” We’re still dancing.” (Financial Times, July, 2007) which was published in 1913. Keynes left the India Ofce and joined the Treasury Department. He was the senior member of the delegation to Paris Over 70 years earlier, Keynes wrote, “This battle of wits to anticipate the basis in 1919 that helped negotiate what became the Treaty of Versailles. Keynes of conventional valuation a few months hence, rather than the prospective yield resigned and left Paris when his warnings were not headed about the dangers of an investment over a long term of years … can be played by professionals the harsh reparations demanded on Germany by the allies could cause. He amongst themselves. For it is, so to speak, a game of Snap, of Old Maid, of Musical subsequently wrote “The Economic Consequences of the Peace” (1919) which Chairs - a pastime in which he is victor who says Snap neither too soon nor too late, turned out to be prescient. Keynes wrote “The General Theory of Employment, who passes the Old Maid to his neighbor before the game is over, who secures a Interest and Money,” (1936) considered his most important book. It spawned a chair for himself when the music stops. These games can be played with zest and revolution in economic thinking, introducing the feld of macroeconomics and enjoyment, though all players know that it is the Old Maid which is circulating, Keynesianism; a distinct school of economic thought. Keynes was also part of or that when the music stops some of the players will fnd themselves unseated.” the British delegation to the United Nations Monetary and Financial Conference (Keynes, 1936) also known as the Bretton Woods Conference at New Hampshire in 1944 which was responsible for the establishment of the International Monetary Fund and the World Bank. 1 Keynes, J.M., (1972) The Collected Writings of John Maynard Keynes: Essays in Biography, My Early Beliefs, Volume 10, Pg 447-50, London, Macmillan. uncertainty; nor is the prospect of a Victory bond being drawn. Or, again, the Less well known, is Keynes contributions to the feld of behavioral fnance; the expectation of life is only slightly uncertain. Even the weather is only moderately study of the infuence of psychology on market participants. Even less is known uncertain.” (Keynes, 1973) The sense in which Keynes uses “the term is that in about the fact that Keynes was in his day, a very successful money manager and which the prospect of a European war is uncertain, or the price of copper and investor, operating an investment vehicle called The Syndicate, which were it the rate of interest twenty years hence, or the obsolesce of a new invention … to be around today would be appropriately described as a hedge fund. Perhaps about these matters there is no scientifc basis on which to form any calculable were Keynes achievements in economics less monumental, more attention probability whatever. We simply do not know.” (Keynes, 1973) would have been paid to his work on the psychology of markets and to his record as an investor. “Keynes highlighted the role of psychology in economics long before behavioral economics and fnance were formed” as a distinct And yet, we fnd ourselves forced by an over abiding inability to tolerate feld of study. (Shefrin, 2011) Prior to Keynes writings on the subject, a few uncertainty, overlooking this practical impossibility and acting as if the signifcant works on psychology and market participants had been published, future were predictable. We are compelled by a certain unacknowledged some of which were, Charles Mackay’s “Extraordinary Popular Delusions and crippling anxiety to pretend that the future is more certain than it is. Never the Madness of Crowds” (1841) about crowd behavior and fnancial swindles. acknowledging what we do not and cannot know, we predict the future. Gustave Le Bon’s infuential book, “The Crowd: A Study of The Popular mind” “Peace and comfort of mind require that we should hide from ourselves how little (1895), which was about the social psychology of crowds. “The Psychology of we foresee. Yet we must be guided by some hypothesis. We tend, therefore to the Stock Market” (1912) by George Charles Selden, on the mental attitudes of substitute for the knowledge which is unattainable certain conventions, the chief market participants and their infuence on price movements especially in the of which is to assume, contrary to all likelihood, that the future will resemble the short term. But the dominant school of economic thought was the classical past. That is how we act in practice.” (Keynes, 1973) school which gave us the rational man. That human beings were rational, fully optimizing economic agents was, and continues, to be the accepted view The assumption that the future is likely to be more similar to the past than an among mainstream economists. But Keynes disagreed. In “My Early Beliefs” examination of the past would show it to be is one of the techniques we have he states that as time went by, the falsity of the view that human nature was devised to help us with our need to predict. We also assume that current prices reasonable became clearer to him. He states further that this “view of what are correct and rationally derived unless something new shows us that it is not; human nature is like, both other people’s and our own…was disastrously and, when we are unable to form individual opinions on the future, we behave mistaken.” “We are,” he says eloquently, “as water-spiders, gracefully skimming, as if the rest of the world is better informed and we accept the judgement of as light and reasonable as air, the surface of the stream without any contact at the majority as a true predictor of the future. (Keynes, 1973) Today, this latter all with the eddies and currents underneath.” (Keynes, 1972) This paper will be convention is more commonly known as “herd mentality”. These, according to in two parts. The frst part will be a discussion about Keynes main ideas on Keynes are the main techniques by which we hide from ourselves our inability the irrationality underlying much of human behavior and how that infuences to predict the future. investment decisions. The second part of the paper will focus on some of Keynes speculating and investing behavior. “The psychology of a society of individuals each of whom is endeavoring to copy the others leads to what we may strictly term a conventional judgement.” (Keynes, 1. keynes and The behavior of 1973) Conventional judgement can compound market errors, because the basis markeT ParTiciPanTs for the judgment itself is unquestioned and accepted as correct even if is in error. We saw evidence of this most recently in the events leading up to the credit In forming our expectations about the future, we often will not attach great crisis of 2008/2009, when conventional judgment held by market participants weight to matters about which we are uncertain, even if those matters are was that house prices never go down. Based on this assumption securities were decisively relevant to the issue about which we are forming our expectations. created, bundled and sold to investors around the globe, culminating in the Our need to predict what might happen in the future even though the future credit crunch of 2008 and the Great Recession, which was the worst fnancial is uncertain, is, says Keynes, a result of our need to escape the crippling anxiety crisis since the Great Depression of the 1930s.
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