Trading Under the Influence of Emotion
This morning, we bring you the latest installment of your brain on stocks -- our ongoing look at how your wetware constantly leads you into making really bad trading and investment decisions. Don't blame yourself; it isn't your fault. You were built that way.
Today's edition looks at the impact of wholly unrelated, nonfinancial emotions on an investor's propensity to take risks.
To do so, University of California-Berkeley professor Terrance Odean of the Haas School of Business (with Eduardo B. Andrade, professor at the Brazilian School of Public and Business Administration and Shengle Lin, assistant professor at San Francisco State University) ran an interesting experiment: They took 495 students and tried to measure how watching an exciting or a scary movie altered trading decisions.
The researchers attributed three emotional states that "varied in both intensity and whether they were positive or negative: excitement (high intensity and positive), calm (low intensity and positive), and fear (high intensity and negative)" to a specific type of film.
The results: participants who experienced intense positive emotions prior to trading—for example, those who watched action films such as Knight and Day with Tom Cruise —were more aggressive, pushing prices up until the final rounds. Those who watched scary movies—such as Stephen King's Salem's Lot or the environmental film, Peace in the Water—proceeded more cautiously.
As you might have guessed, the impact on equity prices was consistent with the participants' emotional state, showing "larger asset pricing bubbles in magnitude and amplitude in the excitement treatment relative to a treatment of same valence and lower intensity (calm) and a treatment of similar intensity and opposite valence (fear)." The following chart tracks this:
The full results will be published in a forthcoming edition of the Review of Finance, "Bubbling with Excitement: An Experiment."
The results are significant for several reasons. First is to recognize how pliable your mind is based on various or irrelevant inputs. Even something as benign and random as whether it's sunny or cloudy affects markets and traders' collective psyches (See this, this, and this; contra this and this).
But the results are significant beyond the impact on any one individual trader. Odean observes that we can expand our understanding of how asset bubbles inflate: "As asset prices went up and investors got excited, they were more likely to do uncritical buying and drive prices up more." In other words, the thrill of a booming stock market can potentially generate even greater speculation and further inflate prices:
Historical accounts suggest that rapid, unexpected increases in wealth during the appreciation phase of asset pricing bubbles can lead investors to experience intense, positive emotions. We document, in an experimental setting, that magnitude and amplitude of bubbles is greater when, prior to trading, traders experience the high-intensity, positive emotion of excitement than when they experience either the low-intensity, positive emotion of calm or the high-intensity, negative emotion of fear. Thus, the excitement generated by rapidly rising prices in real-world markets may trigger emotions that lead to larger asset pricing bubbles.
Rapidly rising prices beget booms, which can turn into bubbles, all of which eventually burst.
While all market participants need to be aware of their own emotional state, it may be even more important to be cognizant of the emotional excitement levels of the crowd. How enthusiastic they become can determine whether a bull market gets out of hand.
Now if only we had a surefire way to measure that.
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