Monday, February 8, 2010

Psychology of Money

brains!Image by cloois via Flickr
Did you know how psychology affects money? You may be surprised to find how much psychology dominates thinking about money. It even trumps logic. How? Let me illustrate.

One of the experiments economists and psychologists play on people is known as the ultimatum game. The rules are simple: you need two subjects, let's call them A, and B.

Experimenter gives A $100, and tells A, and B, that A needs to share with B. If B rejects the offer, than experimenter gets all $100 back, so neither A nor B gets anything. Both A and B should think about the amount, and come up with a strategy to maximize one's own gain. So, what should A do? And what should B do?

Logically speaking, B should accept WHATEVER A offers, because it's better than nothing. If he says no, he gets nothing. So he should ALWAYS say yes. By the same logic A should offer as little as possible, in order to maximize his gains.

However, that almost NEVER happens in reality. In reality, B often rejects small offers, as though an offer that's 'too small' offends his or her dignity. The ability to "spoil" the offer, or "spite", is used as a bargaining chip. Either offer me something good, or you get nothing! So A offers up to 50% of $100 in order to secure the cooperation of B.

In other words, psychology trumps logic, when it comes to humans. And because investors are human, psychology is a major component in financial calculations that drive the stock market and such.

Here is another thought experiment: Say you are in a group of 100 people. Everybody must guess within 80% of the AVERAGE of the number the group picks between 0 to 100. Whoever gets the closest gets $100. You cannot confer with any one else. And everybody has the same amount of time to pick. What number should you pick? You have 30 seconds.

The LOGICAL answer is ZERO. 80% of 0 is still 0. However, those smart enough to realize the answer is ZERO immediately is in the MINORITY, and to win, you have to guess out of the 100, how many would be smart enough to guess 50, then 80% of that (40), then 80% of that... you get the idea. Everybody else will eventually come up with the answer zero, but it will take them a lot of time to do it. So, how smart are the people, and how many iterations of that can they do in the time given (in this case, 30 seconds)?

So how does this relate to investing? Guessing at the "right" price level for a stock is a lot like guessing at the right number in the example above. One of the "rules" of Wall Street that in the LONG term, the market is logical, and will "reach 0" like the example, by arriving at the "proper value" of the price. However, in the short term, the market can act irrationally, as people go over, under, and every which way, until the price eventually reach the "proper value".

Profit in stocks is made when the short-term psychological factors force a divergence of the stock price from its "intrinsic value". If the stock is cheaper than the intrinsic cost, you buy low and sell high. If the stock is more expensive than the intrinsic cost, you sell high and buy low (short the stock). Of course, you have to know the "intrinsic" value of a stock to know whether it's undervalued or not.

A lot of the technical analysis tools have their justification/reasoning in investor psychology. One such thing they try to measure is the accumulation/distribution levels: CCI, Chaikins, MFI, etc. By identifying overbought (too high) and oversold (too slow), these are used to confirm pricing trends and signals generated by other technical indicators.

Some of the Japanese candlestick patterns claims to be based on investor psychology as well. Personally, I think those are backwards: looking for pattern in chaos, and attempt to justify the result because there is no scientific basis for the theories. Still, if you find them useful, go right ahead.

To summarize, a lot of investing is about psychology, and how to take advantage of the mass psychology to exploit the difference between depressed or elevated prices and proper prices.

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