Psychology influences markets, research confirms

Jul 01, 2013 by Marcus Woo
Psychology influences markets, research confirms

When it comes to economics versus psychology, score one for psychology. Economists argue that markets usually reflect rational behavior—that is, the dominant players in a market, such as the hedge-fund managers who make billions of dollars' worth of trades, almost always make well-informed and objective decisions. Psychologists, on the other hand, say that markets are not immune from human irrationality, whether that irrationality is due to optimism, fear, greed, or other forces.

Now, a new analysis published in the XX issue of the Proceedings of the National Academy of Sciences (PNAS) supports the latter case, showing that markets are indeed susceptible to . "There's this tug-of-war between economics and psychology, and in this round, psychology wins," says Colin Camerer, the Robert Kirby Professor of Behavioral Economics at the California Institute of Technology (Caltech) and the corresponding author of the paper.

Indeed, it is difficult to claim that markets are immune to apparent irrationality in human behavior. "The recent financial crisis really has shaken a lot of people's faith," Camerer says. Despite the faith of many that markets would organize allocations of capital in ways that are efficient, he notes, the government still had to bail out banks, and millions of people lost their homes.

In their analysis, the researchers studied an effect called partition dependence, in which breaking down—or partitioning—the possible outcomes of an event in great detail makes people think that those outcomes are more likely to happen. The reason, psychologists say, is that providing specific scenarios makes them more explicit in people's minds. "Whatever we're thinking about, seems more likely," Camerer explains.

For example, if you are asked to predict the next presidential election, you may say that a Democrat has a 50/50 chance of winning and a Republican has a 50/50 chance of winning. But if you are asked about the odds that a particular candidate from each party might win—for example, Hillary Clinton versus Chris Christie—you are likely to envision one of them in the White House, causing you to overestimate his or her odds.

The researchers looked for this bias in a variety of , in which people bet on future events. In these markets, participants buy and sell claims on specific outcomes, and the prices of those claims—as set by the market—reflect people's beliefs about how likely it is that each of those outcomes will happen. Say, for example, that the price for a claim that the Miami Heat will win 16 games during the NBA playoffs is $6.50 for a $10 return. That means that, in the collective judgment of the traders, Miami has a 65 percent chance of winning 16 games.

The researchers created two prediction markets via laboratory experiments and studied two others in the real world. In one lab experiment, which took place in 2006, volunteers traded claims on how many games an NBA team would win during the 2006 playoffs and how many goals a team would score in the 2006 World Cup. The volunteers traded claims on 16 teams each for the NBA playoffs and the World Cup.

In the basketball case, one group of volunteers was asked to bet on whether the Miami Heat would win 4-7 playoff games, 8-11 games, or some other range. Another group was given a range of 4-11 games, which combined the two intervals offered to the first group. Then, the volunteers traded claims on each of the intervals within their respective groups. As with all prediction markets, the price of a traded claim reflected the traders' estimations of whether the total number of games won by the Heat would fall within a particular range.

Economic theory says that the first group's perceived probability of the Heat winning 4-7 games and its perceived probability of winning 8-11 games should add up to a total close to the second group's perceived probability of the team winning 4-11 games. But when they added the numbers up, the researchers found instead that the first group thought the likelihood of the team winning 4-7 or 8-11 games higher than did the second group, which was asked about the probability of them winning 4-11 games. All of this suggests that framing the possible outcomes in terms of more specific intervals caused people to think that those outcomes were more likely.

The researchers observed similar results in a second, similar lab experiment, and in two studies of natural markets—one involving a series of 153 prediction markets run by Deutsche Bank and Goldman Sachs, and another involving long-shot horses in horse races.

People tend to bet more money on a long-shot horse, because of its higher potential payoff, and they also tend to overestimate the chance that such a horse will win. Statistically, however, a horse's chance of winning a particular race is the same regardless of how many other horses it's racing against—a horse who habitually wins just five percent of the time will continue to do so whether it is racing against fields of 5 or of 11. But when the researchers looked at horse-race data from 1992 through 2001—a total of 6.3 million starts—they found that bettors were subject to the partition bias, believing that long-shot horses had higher odds of winning when they were racing against fewer horses.

While partition dependence has been looked at in the past in specific lab experiments, it hadn't been studied in prediction markets, Camerer says. What makes this particular analysis powerful is that the researchers observed evidence for this phenomenon in a wide range of studies—short, well-controlled laboratory experiments; markets involving intelligent, well-informed traders at major financial institutions; and nine years of horse-racing data.

Explore further: When shareholders exacerbate their own banks' crisis

More information: "How psychological framing affects economic market prices in the lab and field" PNAS,

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3.7 / 5 (3) Jul 01, 2013
Conservative economics is primarily just mindless fantasy. This is particularly true of Austrian Economics which has failed every test put to it.

Still the Libertarians and gullible Randites insist that unregulated markets are rational and optimal, when all of the evidence points to the contrary.

Morons and Fools.
1.6 / 5 (7) Jul 01, 2013
You're right, the world is full of too many people with childish outlooks such as your own, they need to be saved from the "big bad wolf". They prefer not to act as adults and be responsible for their own well being and that of their families, but need the protection from their masters. Those who behave irrationally should be saved from failure by the rational because it's "the right thing to do", it's the new Amerikan way, privatized profits, socialized failure. Go ahead and try to point to one fiat monetary system that has lasted for much longer than 100 years before collapsing. The list will be short if it exists at all, every fiat monetary system in the history of the world has failed, a track record which will continue in perpetuity.
1.7 / 5 (6) Jul 01, 2013
In a casino, the odds are always tipped in favor of the house. The game with the best odds against the house is Blackjack, but the house will ultimately win. In the financial markets, as an individual investor, you are going to be royally reamed by rigged outcomes from brokerages that trade at nano-second speeds while you're making ill-informed decisions based on second and third hand strategies. You cannot win because the stock market, a con game, is designed to make you lose. Psychologically, innocent dupes can't believe that someone in an office on Wall Street would do them harm. Horse racing is also prone to fixing where jockeys pull the reins on a favored horse. The value of anything is arbitrary- including and especially money. The world has agreed that money has value, but if a large enough group decided it has none, the actual value of money would tumble. What we've been seeing in the world is a waning of faith in the value of money and governments that guarantee its value.
1.6 / 5 (7) Jul 01, 2013

"The consumers patronize those shops in which they can buy what they want at the cheapest price. Their buying and their abstention from buying decides who should own and run the plants and the farms. They make poor people rich and rich people poor. They determine precisely what should be produced, in what quality, and in what quantities. They are merciless bosses, full of whims and fancies, changeable and unpredictable. For them nothing counts other than their own satisfaction. They do not care a whit for past merit and vested interests. If something is offered to them that they like better or that is cheaper, they desert their old purveyors. In their capacity as buyers and consumers they are hard-hearted and callous, without consideration for other people."
Why do economists think markets are rational? Probably because they don't know how to model irrationality and therefore can't be of service to central planning socialists.
1.6 / 5 (7) Jul 01, 2013
"It is true, in the market the various consumers have not the same voting right. The rich cast more votes than the poorer citizens. But this inequality is itself the outcome of a previous voting process. To be rich, in a pure market economy, is the outcome of success in filling best the demands of the consumers. A wealthy man can preserve his wealth only by continuing to serve the consumers in the most efficient way."
"In an unhampered market economy the capitalists and entrepreneurs [p. 273] cannot expect an advantage from bribing officeholders and politicians. On the other hand, the officeholders and politicians are not in a position to blackmail businessmen and to extort graft from them. " {Our present system,which is NOT free market.}
2.3 / 5 (3) Jul 01, 2013
"They determine precisely what should be produced, in what quality, and in what quantities." - Mises

Quite impossible since the consumer has no control over the manufacture of products, selection of products that are manufactured, or information detailing how those products are produces, or even what their characteristics are after they are purchased.

Earlier today I was listening to a friend of mine tell me how a friend of his had the window of his car fall into the door cavity - the second car of 2 to do this within a week - due to plastic clips being used to hold the window in place in the window movement mechanism.

The knowledge of how those clips were manufactured, as well as the material from which they were manufactured were hidden from the consumer. As a result the manufacture could use cheap parts to manufacture a cheap product that fell apart.

No one wants windows 8. Why did Microsoft produce it after they were repeatedly told it did not fulfill the needs of the user
2.3 / 5 (3) Jul 01, 2013
"To be rich, in a pure market economy, is the outcome of success in filling best the demands of the consumers." - RyggTard

If consumers had perfect knowledge of the products they were purchasing, perfect control over how those products were manufactured, and acted as perfectly rational decision makers, then there is a remote chance that RyggTard's ideological imperative might be right.

However, as this article clearly states and as he clearly ignores, people are not rational actors, and the market provides them with insufficient information to make rational decisions.

As a result the statement of his Libertarian ideological imperative turns out to be nothing but an exercise in Libertarian and public masturbation.

Mindless. He is incapable of learning. His response to research disproving the basis of his Political ideology is to restate the basis of his failed political ideology.

Absolutely Mindless

2.3 / 5 (3) Jul 01, 2013
"Go ahead and try to point to one fiat monetary system that has lasted for much longer than 100 years before collapsing." - CantDriveTooDumb

Mindless Tea-bag-ism's.

Somehow Tea-Baggers have gotten it into their minute little brains that in order for the value of the dollar to be safe from dilution by printing, it must be based on the value of gold in a valt.

But that is nothing more than a claim that the face value of the sum of all dollars can not exceed the value of the gold in a valt, which is equivalent to a prohibition on printing dollars.

It never occurs to their tiny little brains that such a prohibition is independent on weather the currency is based on gold or some other property, such as the popularity of the dollar itself.

They are a gaggle of small, paranoid minds, which are only capable of small, paranoid thoughts.
1 / 5 (6) Jul 01, 2013
The problem here is equating institutional investors like hedge fund managers with sports betters. They're more like professional poker players - they're there to make money. The big money is very rational. It's the small money that isn't, and the problem with research like this coming out of academia is too often that the researchers think with their own wallet.
3 / 5 (2) Jul 01, 2013
"The big money is very rational." - Ducket

Which is why major U.S. investment banks went bankrupt 5 years ago.

How short the memory of a fool can be.
1 / 5 (7) Jul 02, 2013

How old are you anyway? I would have thought old enough to get beyond juvenile sexual slurs, but of course, some people never grow up.

So perhaps it's time to for you go toss a salad, and do some fudge packing for dessert.
5 / 5 (1) Jul 02, 2013
Actually, the Socionomics Institute in tandem with Elliott Wave International has been studying how social mood affects the stock markets for decades. That tells me PNAS is decades behind in its research.
1 / 5 (4) Jul 02, 2013
Anyone here on this board or anywhere else who votes for a closed economic system (read controlled), where all variables are defined, all outcomes known, and all actions to move from point A to point B are delimited, is asking for entropy where activity levels move inexorably towards chaos, energy depletion, and stone-like life circumstances for its inhabitants. We will discover nothing, work for nothing, and live for nothing. Our living environment will determine future. I was raised in a one-bedroom apartment and now live in a house, because our society was rich enough to tinker with its resources, which made us rich enough to tinker with our resources, which made us rich enough to tinker with our resources. We live in a dynamic, open system that can and does change on a dime. Try to understand, please, why it was never possible for dolphins, no matter how innately intelligent, to invent fire. They could not tinker! They could not fail and they could not succeed!
not rated yet Jul 02, 2013
"I would have thought old enough to get beyond juvenile sexual slurs, but of course, some people never grow up." - GeoksTard

Sorry Tardie Boy, but "tea-bagger" is what the "tea-baggers" originally called themselves.

They were too stupid to know that the term was already in use.

Why shouldn't we use the same label that they did?

Because you don't like it?

Awwww... You poor little Tea-Bagger.

not rated yet Jul 02, 2013
"why it was never possible for dolphins, no matter how innately intelligent, to invent fire. " - FoopDieDoo

Perhaps it was because they can't light matches with their flippers and when they light them with their noses, the water they live in puts the fire out.

Just ask any dolphin... They will tell you.
not rated yet Jul 02, 2013
"We will discover nothing, work for nothing, and live for nothing." - JoopDieDoo

On the contrary, money has always been an impediment to discovery and creativity.
1 / 5 (2) Jul 06, 2013
Other than another superficially obvious article tag line proclaiming "confirmation" of what isn't exactly described, it starts of with "Economists argue that markets usually reflect rational behavior". Which uses the weasel word "usually" meaning that when they are irrational that doesn't make them wrong either.

Then, "hedge-fund managers who make billions of dollars' worth of trades, almost always make well-informed and objective decisions." Almost always means sometimes they don't.

Then, "Psychologists, on the other hand, say that markets are not immune from human irrationality," Meaning that usually they are rational, but sometimes they aren't.

Then, " it is difficult to claim that markets are immune to apparent irrationality in human behavior." Wait, no one has made that claim yet. And to weasel it by saying "it is difficult to" means this sentence doesn't claim anyone has claimed it either.

At this point I stopped reading.

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