Cognition, market sentiment and financial instability

Abstract

Quantitative models have been a central part of the story of the present financial crisis. It was the models used in financial markets which provided the basis for an assessment of risk exposure which went so badly wrong (see eg Haldane 2009). But economists' models too failed to capture the systemic risk which resulted from market behaviour (see eg Colander et al. 2009). Alan Greenspan's remark, quoted above, is thus interesting in two respects. First, he identifies the problem as a failure to model the turnaround at the peak of the cycle. Second he depicts the cycle in psychological terms, such that the turnaround is one from greed to fear. The task for economists would appear to be to incorporate psychology more successfully in economic models so that financial instability can in future be predicted and understood better. 2The focus of this paper is therefore on how, and in what way, psychology can contribute to our understanding of financial instability, as input to modelling by the monetary authorities or otherwise. It will be argued that there is a correspondence between the view taken of modelling on the one hand and the way in which psychology can be incorporated on the other. The argument has been made (Dow 2004) that formal modelling (and particularly the search for the single best model) cannot be the full answer to understanding the economy, far less prediction. Any one model can only provide partial knowledge, to be supplemented by other forms of knowledge, including judgement (an argument expressed most recently in relation to the present crisis by Lawson, 2009). Indeed Downward and Mearman (2008) have argued that this process can usefully be understood as the application of the method of triangulation. In contrast, the behavioural finance literature aims to adapt rational choice models using inputs from psychology. Was the failure of most economists to anticipate the crisis due, as Alan Greenspan suggests, to insufficient development in the capacity to model changes in sentiment?In exploring the use of psychology in behavioural finance, the focus will be on the distinction drawn between cognition and emotion (sometimes expressed as the distinction between rationality and irrationality). This distinction itself is then probed in order to discuss the limitations of the behavioural economics approach, and then to develop an alternative approach which draws more on social psychology and feeds into a (Minskyan 1 ) structural explanation of financial instability. 2 According to this alternative 1 For surveys of Minsky's thought, see Dymski and Pollin (1992), Papadimitriou and Wray (1998, 2009), Fazzari and Papadimitriou (1992), Dymski and Pollin (1994), Bellofiore and Ferri (2001) and de Antoni (2006). 3 approach, there is no sharp division between cognition and emotion; indeed cognition rests on emotion, and both have an important social dimension. Decisions can be more or less reasonable (in relation to reality) but always involve some sentiment or emotion. The implications of the two (behavioural f...

Medical professionals’ responses to a DRG performance management system for hospital care in the Netherlands. Reinterpreting ‘perverse effects’, such as upcoding and patient selection, using arguments of professionalism and managerialism

“…Driven by self-interest, professionals are expected to exploit their autonomous position for opportunistic and rent-seeking behaviour (Garoupa 2004 (Waterman and Meier 1998, Brignall and Modell 2000, Miller 2005, Shapiro 2005, Steenhuisen 2009). The presumed opportunistic and self-interested nature of the agent is also considered to be an oversimplification of reality (Heinrich and Marschke 2010, Dow 2011, Moynihan, Pandey and Wright 2012 (Miller 2005, Shapiro 2005). As we read above, scholars have challenged, for instance, the assumptions of preference asymmetry and the dyadic nature of principal-agent relations.…”

“…In this respect, the classic paradigm has been criticized because it fails to consider the idea of a cooperative relationship between principal and agent. Indeed, various scholars argue that agents have more modes of action at their disposal than just self-interest (Perrow 1986, Etzioni 1988, Fehr and Falk 2002, Dow 2011, Cuevas-Rodríguez, Gomez-Mejia and Wiseman 2012, Moynihan, Pandey and Wright 2012. Thus, the motivations that drive choices agents make range from pure opportunism and selfinterest to pure fiduciary and pro-social purposes.…”

The Roles of Investor Sentiment in Malaysian Stock Market

“…In behavioural finance worldviews, understanding sentiment is important for theory, investment practice, and policy. In theory, sentiment cannot be ignored in the true risk assessment because market participants rely on heuristics and sentiment (Dow, 2011). In investment practice, behavioural risks have a role to play because the stock prices are much too variable than the fundamental (Akerlof & Shiller, 2009).…”

“…In investment practice, behavioural risks have a role to play because the stock prices are much too variable than the fundamental (Akerlof & Shiller, 2009). In policy perspective, Alan Green remarks that failure to anticipate financial crisis is partly due to insufficient development to model changes in sentiment (Dow, 2011). As such, a theory of investor sentiment warrants further scrutiny to validate its theoretical foundations and to defend its empirical claims.…”

“…In psychology perspectives, Cooley (1909, as cited in Stets [2003) defined sentiment as feeling raised by thought and intercourse with others minds. Sentiment is interconnected with cognition and decisions always involve some sentiment (Dow, 2011). In finance research, the word sentiment has been variously defined as an index expressing an opinion, irrational beliefs, erroneous beliefs, and investor opinions, on the expectation for future cash flows and investment risk (Solt & Statman, 1988;Morck, Shleifer, & Vishny, 1990;Barberis, Shleifer, & Vishny, 1998;Shefrin, 2008;Chang, Faff, & Hwang, 2012).…”