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The Psychology of Finance

(updated 2020)


To some, the statement, “the psychology of financial matters,” will feel like an oxymoron. But, it’s actually a fairly accurate reflection of reality. At first assumption, finance seems as if it should be an objective and logical science. But, derivatives of mathematics do not necessarily retain all of the same characteristics as the parent. Like most derivatives, the ultimate behavior is inextricably tied to human behaviors.

We may rule the world, but we are still vulnerable to nature, each other, and unknowns. We’re more optimistic when we are secure and confident in knowing what comes next in our story. We’re arguably much more pessimistic when we cannot be certain as to how our story ends. And when there are threats, and the magnitude of the impact from those threats cannot be known, fear will persist.

Banking
On October 14, 2008, the Treasury implemented the Troubled Assets Relief Program, which infused cash into institutions by purchasing illiquid assets, and the Capital Purchase Program, a subprogram, that provided a capital injection by way of the purchase of preferred stock. These efforts were intended to help financial institutions to stabilize their balance sheet, and to become willing to lend again to prime borrowers, and stimulate the economy. Many banks took the money, ($300 billion total); but, they hoarded the funds, and the goal of increased systemic liquidity was never realized. Recipients feared they may need the money later, for themselves; that additional assets might deteriorate, and that regulators would require yet more capital to cover fresh losses. Granted, the fear was not entirely unfounded; but, by this time, the systemic problems had been identified. It was after the March 2008 sell-off of Bear Sterns, the July 2008 IndyMac Bank failure, the September 2008 Lehman Brothers failure, the September 2008 Washington Mutual Bank failure, and the September 2008 AIG Bailout. The issues at these institutions were well known before it became a public disaster. That's the nature of bank regulation. Regulators are on the front lines identifying the weaknesses, and management's plan for resolution. When management can't figure it out, regulators step in; bankers know this. So, when the Federal Reserve devised a plan for aid, they were offering more than just a temporary bandaid; they were providing a substantial life raft to help ensure institutions could weather the storm.

Other financial institutions refused receipt of TARP funds for fear that shareholders would perceive them as weak or undisciplined for needing  government funds for continuing operations. The problem was systemic and not necessarily indicative of risky behavior, at least not for the majority of institutions.  Nonetheless, machismo prevented many from accepting much needed help. Descartes once said, “I think therefore, I am,” however, sometimes, we think too much. 

Neither ideology concerning TARP really served the intended purpose. Fear ruled the day, and we effectively “psyched” ourselves out.

Amazingly, during the 2020 COVID-19 Crisis, the exact opposite phenomenon was witnessed as banks flocked to government programs to demonstrate to stakeholders that they had sufficient liquidity. But, then a lot of lessons were learned from the 2008 Financial Crisis, and the Federal Reserve stepped in immediately with a plethora of new and different programs to avert a liquidity crisis.

Wall Street
On Wall Street, pricing is more than just a simple function of reward or punishment for actual performance. Pricing incorporates a degree of speculation concerning future performance, based on current sentiment: do we “feel good” about the prospects, and to what degree of certainty can we say our feeling is accurate? Is it an inevitable plausibility, or a faint and distant marginal possibility? Yes, statistics, probability, calculus, and maybe even a little algebra can be in these considerations, when you are trying to arrive at the conclusion. But, the outcome is being driven by a qualitative wet finger in the air trying to gauge which way the wind is blowing, and how much fear may be warranted.

We have witnessed huge swings in the stock market, for no real apparent reason. A great example are the swings throughout the later half of 2011 when in August, October, and December large changes were likely triggered by the August 8, 2011 downgrade of sovereign debt from AAA to AA+. Still high quality investment grade debt, and likely the ratings agencies attempt to rectify some past wrongs. But, the response was as if the debt quality had fallen to BBB+. Fear permeated the air, and the ensuing  volatile market schizophrenia was a direct reflection of our global sentiment. Other swings are more predictable and warranted, such as the March 2009 and March 2020 declines that directly correspond to cataclysmic events, e.g. the Financial Crisis and COVID-19. At these times, it probably seemed like the sky was falling. When the masses feel like this, stocks fall, and security blankets rise, in the form of gold prices and bank deposits.

In May 2012, CNN Money built a model to capture sentiment, as a measure of fear vs. greed. Their Fear & Greed Index includes seven equally weighted indicators to arrive at an overall sentiment:

  • Stock Price Momentum: The S&P 500 versus its 125-day moving average
  • Stock Price Strength: The number of stocks hitting 52-week highs and lows on the New York Stock Exchange
  • Stock Price Breadth: The volume of shares trading in stocks on the rise versus those declining.
  • Put and Call Options: The trading volume of bullish call options / trading volume of bearish put options
  • Junk Bond Demand: The spread between yields on investment grade bonds and junk bonds
  • Market Volatility: The VIX which measures volatility
  • Safe Haven Demand: The difference in returns for stocks versus Treasuries




This model is not intended to be not an indicator to buy or sell assets, but as a general indicator of market sentiment.

Consumers
At 70% of GDP consumer spending drives the economy. But, all purchases are not equal - some drive our emotions, while others are driven by our emotions.

Ninety-five percent of Americans shop online at least yearly, 80% shop online at least monthly, 30% shop online at least weekly, and 5% shop online daily. And despite the convenience of online shopping, brick-and-mortar stores still account for ~90% of all retail sales in the US, with ~70% of all shoppers admitting to spending more when they shop at brick and mortars. That’s because shopping remains one of America’s favorite pastimes; it’s often a social outing, a fun excursion with friends and family, promising to culminate in the fulfillment of a need, want, or desire. Happy social activities flood your system with feel good endorphins.

We may experience stress and anxiety when faced with a critical purchase, such as one that requires a long-term commitment, (e.g. a house), or one that will make the difference between abundance or scarcity, (e.g. groceries before a winter storm, or a pandemic). Stress releases a not so feel-good hormone, cortisol, to regulate your fight-or-flight response.

Then there are times that we make purchases specifically to relieve stress, those impulse buys - the splurge on the junk food or designer handbag that we don’t need. Or maybe you engage in retail therapy. If so, you’re not alone. Depending on which study you believe, ~65% of shoppers say they’ve also shopped to relieve stress. I googled “retail therapy” and arrived at an theory at Psychology Today, an advisory at Experian, and referenced psychological studies on Forbes. So it’s definitely a thing.

Our emotions are inextricably tied to money, directly and indirectly, and for business and personal purposes. But, to be human is to be an emotional beings, as well. As since humans created our economic and financial systems, it really should be no big surprise that psychology makes a guest appearance.