Sustainable Investment and Corporate Governance Working Papers, Sustainable Investment Research Platform
No 2009/7:
Psychology, Financial Decision Making, and Financial Crises
Tommy Gärling ()
, Erich Kirchler, Alan Lewis and Fred van Raaij
Abstract: It is understandable in times of financial crisis that the
general public asks how this could happen. And since the market actors
appear so irrational, it is also understandable that people – lay people
and experts alike – believe that “psychological” factors play a decisive
role. Is there evidence for this and what is the evidence? It is true that
in general people individually use their cognitive and other resources in
sensible ways, and that they collectively have developed institutions that
effectively regulate economic and other transactions. It is likewise true
that extreme circumstances sometimes are beyond people´s capacity,
individually as well as collectively. It is therefore essential that
scientific knowledge of people´s cognitive and other limitations is brought
to bear on the issue of how to prevent such extreme circumstances to occur.
Arguably, financial markets such as those for stocks and credit overtax
actors’ capacity to make rational judgments and decisions. In product
markets with full competition, prices represent the true value of the
products offered. This does however not hold in stock markets where stock
prices, due to excessive trading, are more volatile than they should be if
reflecting the true value of the stocks. Psychological explanations include
cognitive biases such as overconfidence and overoptimism, risk aversion in
the face of sure gains and risk taking and loss aversion in the face of
possible losses, and influences of nominal representation (money illusion)
of stock prices. If no cognitive biases (strengthened by affective
influences) exist or only some actors are susceptible to such biases,
individual irrationality in stock markets would be eliminated. This is
however not what evidence indicates. Still, in order to understand stock
market booms and busts, it is necessary to take into account the tendency
among actors to imitate each other. In de-stabilized stock markets, experts
are less likely to loose money than lay people who lack skill in
constructing stock portfolios that effectively diversify risk.
Credit
markets allow people to lend money for investments that will pay off in the
future. Yet, under extreme circumstances credit lenders offer loans without
appropriately considering the risk borrowers run of not being able to pay
back installment rates. Global credit excesses in general, and the current
sub-prime mortgage crisis in particular, also show that households often
accept risky loans. Furthermore, their preparedness to use credit has been
increasing and credit is no longer solely a means of investing in the
personal future. An example is that, in the new member states of the
European Union, citizens having a desire for a Western living standard are
increasingly prepared to use credit.
Credit use is a process consisting
of different stages of decision making, starting with purchasing a product
for borrowed money and ending with paying back the borrowed money.
Decisions to save now in order to buy a desired product in the future, or
not to save but to borrow money and save later, are intertemporal choices
with consequences at different points in time: The rewards of possessing a
commodity immediately or in the future are traded off against the costs of
paying back borrowed money by installment rates or paying the price at once
in the future.
Purchase decisions involve two interacting choices
preceded by information search: Choice of the product and choice of the
method of financing. In contrast to search of information about the
product, only a small percentage of credit users search extensively for
credit information prior to credit take up. The probability of search
increases with the borrowed amount, the amount of previously experienced
debts, higher income, educational level, and for credit novices.
Furthermore, credit users fail to correctly anticipate the decrease in the
experienced pleasure from the credit-financed product.
They also
experience decreasing pleasure with the acquired product and increasing
strains with the continuing payments. In order to deal with this
hedonically unsatisfactory state, credit users are tempted to borrow again,
and thus possibly slide into problem debt. There is also a reciprocal
interaction between the pleasure derived from consumption and the pain
associated with paying. As long as a purchased product is not fully paid,
pleasure of consumption would be attenuated by painful thoughts about the
remaining payments. Therefore, loan payments would become progressively
less burdensome if the outstanding debt balance and the associated pain are
shrinking more quickly than the benefits of consumption. If payment and
consumption are mentally coupled, credit financing would only be accepted
for long-lasting goods that slowly depreciate in value, so that the pain of
paying is buffered by the benefits derived from the consumption of the
product.
In coping with economic hardship caused by financial crises
and economic recessions, households use a hierarchy of tactics for
adjustment, including buying cheaper, buying less, buying higher quality
(more enduring products), and buying fewer (or selling) durables. Since the
last implies life-stylechanges it is a last resort even though it would be
the most effective way of coping. Younger people are more flexible than
older people. Yet, older people, who have experienced economic recessions
before, are better able to cope than younger people without such an
experience. Pessimistic people and people in lower socioeconomic strata
adjust by buying less, whereas optimistic people and people in higher
socioeconomic strata continue their consumption and lifestyle by buying
higher quality and enjoying more enduring products.
People should be
taught budgeting and “mental accounting” techniques to become aware of the
possibilities of curtailment by taking account of their spending on a
variety of expense categories. The use of credit cards makes mental
accounting more difficult and should therefore be discouraged.
Implementation of counter-measures is however not easy. There are large
differences between people in financial knowledge related to age, gender,
level of education, and occupation. Most people furthermore dislike to
think about and to compare financial products. Many people even lack the
motivation to acquire the knowledge about financial products and procedures
needed to function in a complex financial world, where they increasingly
become responsible themselves and can rely less on the government for
protection and support.
A detrimental consequence of financial crises
is the loss of trust in financial institutions. Seven determinants of trust
(and regaining trust) in financial institutions are discernible:
competence, stability, integrity, benevolence, transparency, value
congruence, and reputation. The first four are necessary pre-conditions or
“dissatisfiers” that bring trust from negative to neutral. The last three
are “satisfiers.” Achieving some or all three would bring trust from
neutral to positive.
Some argue that asset bubbles are started by greed
fuelled by overconfidence and optimism (as well as low interest rates and
inexpensive credit), “madness of crowds” and self-fulfilling prophecies
encouraging people to do things they would not do on their own. This
results in momentum buying where “real” value becomes irrelevant. It
therefore seems fruitless to outlaw mass financial euphoria if it were
imbedded in the “human psyche.” One may ask how financial institutions can
be changed to become more responsible. An example is the inclusion of
long-term environmental, social, and corporate governance considerations
within investment processes to achieve both financial and social outcomes.
This requires removal or change of conventions that favour remuneration
systems based almost entirely on short-term performance. Making required
cultural shifts is however no easy matter but because people in any group,
including those in financial institutions, are not entirely homogeneous,
minorities of open-minded, socially responsible thinkers exist and now
perhaps is the time when they are more likely to be listened to.
A
policy-relevant insight is that whereas increasing material wealth in
already affluent societies has small effects on citizens’ life
satisfaction, shrinking material wealth in times of economic crises and
recessions may have a more profound effect. In affluent societies
preventing shrinking material wealth should therefore have higher priority
than increasing material wealth.
Keywords: Psychology; Financial Decision Making; and Financial Crises; (follow links to similar papers)
82 pages, September 29, 2009
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