March 18, 2009
Wishful Bettors Draw Others Into Dubious Investment Choices

Overly optimistic people end up drawing more knowledgeable investors into unwise investment positions.

AUSTIN, Texas—Wishful bettors, those who make overly optimistic investments, will ultimately harm themselves financially, but they can harm entire markets as well, new research shows.

In the paper, "Contagion of Wishful Thinking in Markets," researchers from The University of Texas at Austin and Cornell University demonstrate how wishful betting can contaminate beliefs throughout markets, as other market participants infer wishful bettors possess more favorable information than they do. As a consequence, investors who initially held accurate beliefs become overly optimistic about stock values. The research will be published in a forthcoming issue of Management Science.

"The findings of our studies contradict what many people assume about markets, that wishful thinkers will be identified and disciplined by more sophisticated investors," said Nicholas Seybert, an assistant professor of finance at the McCombs School of Business at The University of Texas at Austin. "Instead, investors fail to recognize the existence of wishful betting even though most of them do it. As a result, wishful thinking can be contagious in financial markets."

Over the years I've gradually dialed down in my mind my assumptions about the levels of competence in others in higher status positions. One of the biggest mistakes to avoid: just because someone is very competent about topic A that does not mean when they make equally confident statements about topic B that they have a clue as to what they are talking about. So many experts do not realize how ignorant they are outside of their areas of real expertise.

People expect others must know better what they are doing. I think we are all looking for leaders to follow.

Investors started with a short position in half of the stocks and a long position in the other half. The researchers reasoned that investors in short positions would desire low stock values, while those in long positions would desire high stock values. Despite all investors' initially holding unbiased beliefs about intrinsic stock values, those in short positions sold too many shares and those in long positions purchased too many shares. More surprisingly, investors did not anticipate this wishful betting behavior on the part of others. Even though they themselves purchased or sold too many shares of stock, they believed that other investors' trades were based on fundamental information about intrinsic value. By the end of trade, market prices were too extreme and the average investor appeared to be a "wishful thinker" – holding overly optimistic beliefs about intrinsic value.

Beware the confident.

Share |      Randall Parker, 2009 March 18 11:51 PM  Brain Economics


Comments
wcw said at March 19, 2009 6:49 AM:

Having spent over a decade trading and, on balance, beating markets, I agree. Ever and always question your own thinking, but ever and always question the market, too. The real trick is not identifying its mistakes; things like the tech and housing bubbles are easy to see. The trick is to try to profit a little within the bubble, so you survive until you can peg roughly when the market finally is going to wake up. I have found this much, much more difficult.

th said at March 19, 2009 3:25 PM:

Given the last experience with bear stearns, lehman, and all the now redefined investment banks, what level of higher expertise were they guided by? barney frank?

Lou Pagnucco said at March 22, 2009 10:32 AM:

This irrationality of markets has been exploited by manipulators for centuries.

The outing of Jim Cramer is a recent case in point.
Another is the take down of Lehman with supposedly illegal naked-shorting which initiated the current economic debacle.

I suspect most of the recent stock and commodity bubbles were engineered.

Moving markets must be easier now than ever before, given the growing concentration of capital in hedge, "national wealth", university endowment,..., funds - fewer and far more powerful players. Especially worrisome is the advent of the anonymous, paper-trail-free, private "dark pool" exchanges, and other off-the-books trading channels. Looks like a perfect scheme for creating illusory buying/selling pressures by only exposing half of an asset-swap on the public exchanges. What better way to make people think $300/barrel oil is imminent when tankers are backing up in the Gulf for lack of buyers?

Randall Parker said at March 22, 2009 11:19 AM:

Lou,

I do not think bubbles require conscious conspirators to happen. Also, I think lots of promoters of bubbles are too foolish to realize they are promoting something unsustainable.

Engineered: I think the engineers really require what this post reports on: The willingness of the more analytical and rational folks to believe that the Panglossians must know something that the more rational people do not know. The bigger problem here is the human mind as evolution produced it. The innate cognitive biases of humans cause irrationality and inefficiency in markets.

Lou Pagnucco said at March 22, 2009 8:48 PM:

Randall,

No, of course, bubbles can arise spontaneously.

Once started, though, they always attract a very unsavory element.

I had the displeasure of being ejected from a real estate radio talk show, at the height of the bubble, for politely cautioning the listeners that the sponsors' and hosts' hype might prove costly. Certainly the show had an agenda - and it wasn't to help their audience.

I have been met people who have worked boiler rooms, commodity trading pits, and financial journalists, who have related to me too many examples to enumerate. The cognitive biases, you refer to, are what fuel the system.

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