The three psychological reasons that Barberis cites in his paper include the housing bubble that was created leading up to 2006, cognitive dissonance that took place with the risky sub-prime securities holdings and the psychological amplification mechanisms. All three combined to create a “perfect storm” that resulted in the worst financial crisis since The Great Depression.
Barberis first looks at the formation of the real estate bubble which he points out can be explained with theories that look at investors’ beliefs or on investors’ preferences. There are three explanations to the belief-based theory:
- Everyone thinks that an asset is going up and there are few constraints on short selling so the market has created the perception of a “blue sky” on an asset and it keeps getting more expensive.
- People take the past small increases in small sample of assets and carry it too far forward into the future with a very unrealistic optimistic outlook in its performance.
- People get overconfident and develop a confirmation bias where they will look for information that supports their belief and ignore those that contradict it; this results in asset prices going higher.
The two preference-based theory he discusses are the following:
- Investors take more risk when they are playing with “house money,” which happens after the prices have gone up so much that they are willing to risk even more driving prices higher
- Investors tend to view these assets like they are new technology with rose colored glasses thinking they will make a “big killing” like the way people buy tech stocks that are not supported with fundamentals to justify lofty prices.
Out of all the theories, the one according to Barberis contributed to the real estate bubble was that people over-extrapolated the prices of the future growth from the past growth. But it would require more than just individuals alone; it had to occur across many entities including lenders, homebuyers, type of loans that were issued, securitization of the mortgages and rating agencies to create a real estate bubble. Everyone’s hands were dirty that led to “the mother of all the bubbles.’ Barbeis points out that this was nothing new; it had happened before with the US stock market in the 1920s, the Japanese real estate and stock market in the late 1980s and others.
One thing we often hearing and seeing is the common disclaimer that “past performance is not necessarily indicative of future results,” but this is often ignored by many that results in bubbles that, when it bursts, results in a major financial crisis. Unfortunately, we don’t seem to learn from it and keep repeating it every few years.
Barberis provides three views that were advanced for banks having such large positions: “bad incentives”, “bad models,” and “bad luck.”
- The “bad incentives” view was that mortgage desks were motivated by compensation so they simply didn’t care about the potential risks.
- The “bad models” view was that mortgage desks didn’t know about the risks.
- The “bad luck” view was that the poor performance of the subprime-linked-securities was the result of bad luck.
Barberis discounts all of these three views and believes it was something more insidious: cognitive dissonance, meaning that we justify or rationalize something that we are doing that is harmful by manipulating our beliefs so we feel good about our actions. This is exactly what led to accumulating large positions.
Here is how it worked:
- Trader started seeing the subprime securities holding starting to pose a risk
- This creates a discomfort---uncomfortable dissonance
- He can do one of two things to get rid of the dissonance: quit his job or manipulate his beliefs.
- Since he does not want to get hurt financially for quitting the job, he will start manipulating his beliefs (e.g., it is not that risky) and kind of put on “ethical blinders.”
The same thing happened with the credit agencies who were giving AAA ratings to subprime securities that didn’t deserve that rating. Analyst also did that because they thought everything would work out at the end and since these financial instruments were so complex they did not quite understand its risks.
What may have contributed to this manipulation was the complexity of subprime linked instruments and the plausible argument that house prices always tend to go up and thus will not result in any subprime defaults.
Not many asked the most important question: why? Interestingly that was Enron’s slogan, “Ask why?”. Unfortunately, it was too late to ask after it went bankrupt.
Why did the price declines were so large when the actual delinquencies were small?
Besides institutional amplification which occurs when price starts dropping, others start selling to de-lever and this spirals into more losses and more selling and steep decline in prices.
Two theories that explain this fall under psychological amplification: ambiguity aversion and loss aversion.
Ambiguity Aversion which says that people don’t like to take risk when they can’t assign probabilities to how it will turn out though they are aware of basic evidence for it---Ellsberg paradox. But this can change over time and is explained by a theory called “competent hypothesis.” If an individual does not feel competent of analyzing the situation, he will be ambiguity averse. In contrast, if he feels competent, then he will be ambiguity seeking. However, you can alter subjects’ degree of aversion by making them feel more competent by presenting something that is more easy to understand.
During the decline in risky assets, once an investor suffered some initial losses in their holdings of risk assets, they felt less competent at analyzing these assets. This made them more ambiguity averse, leading them to reduce their holdings of risky assets further lowering the prices of these assets.
People are more sensitive to losses than gains of the same magnitude.
Those who suffer loss become even more loss averse, refusing to take gambles that if they had not suffered prior loss, would be willing to take. After suffering a painful loss, people can’t bear to go through another loss. This increases their loss aversion.
With financial assets, once investors started suffering loses, it made them loss averse and made them reduce their holdings which caused the prices to decline even further.
There are lot of factors that led to the the 2007 - 2008 financial crisis, but the point Barberis concludes with is that these three factors occurred in the past and seem to keep recurring, and unless we can spot it early and act appropriately to mitigate its harmful effects and prevent future financial crisis.
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