Distinguished 20th century American sociologist Robert K. Merton is perhaps best known for having coined the term "self-fulfilling prophecy." A central element of modern sociological, political and economic theory, it's a process whereby a belief or an expectation, correct or incorrect, affects the outcome of a situation or the way a person or a group will behave.
Merton took the concept and applied it to the social phenomena of bank runs in the Great Depression. In his book Social Theory and Social Structure, he invents a fictional Last National Bank, overseen by Cartwright Millingville. Mr. Millingville manages the bank in an honest and forthright manner and his, like all banks, has some cash reserves and lends money. One day, a large number of customers come to the bank at once-the exact reason is never made clear. The customers, seeing so many others at the bank, begin to worry. Rumors spread that something is wrong with the bank, and more customers rush there to try to get some money out while they still can. Nervous chatter grows as more people line up, which in turn fuels more rumors of the bank's insolvency, causing more customers to try to withdraw their money. At the beginning of the day, the bank was not insolvent. But the rumor of insolvency caused a sudden demand of withdrawals that could not be met. So the bank became insolvent after all.
Merton concludes with this analysis: "The parable tells us that public definitions of a situation (prophecies or predictions) become an integral part of the situation and thus affect subsequent developments. This is peculiar to human affairs. It is not found in the world of nature, untouched by human hands. Predictions of the return of Halley's Comet do not influence its orbit. But the rumored insolvency of Millingville's bank did affect the actual outcome. The prophecy of collapse led to its own fulfillment."
Some would say the events of 2011 had characteristics of the self-induced "panic" of a fictional bank run as described by Merton. Last year saw exogenous shocks, geopolitical turmoil, deadly natural disasters, financial market strains, rumors of impending sovereign defaults, political squabbling leading to deadlock-the list could go on and on. It was certainly a time when students of behavioral finance would have a field day!
We saw social uprisings in North Africa and the Middle East toppling strongman regimes. Civil war in Libya led to a spike in crude oil prices and the resulting commodity price increases stoked inflation concerns and blunted consumer behavior. We reacted in sorrow to the tragedy of the Great East Japan earthquake and tsunami, followed by disaster at the Fukushima nuclear plant.
The deepening of the sovereign debt crisis in the euro zone and the contagion effect on the banking sector dominated the daily headlines. Confusion reigned and global stock and bond markets saw volatile bouts of increased selling.
If those events weren't enough to fret about, we endured a near shutdown of the U.S. government due to political posturing. That paled in comparison to the nerve-racking game of brinkmanship in Congress over the raising of the federal debt ceiling amid discussions about how to address the country's current annual spending deficits and long-term entitlements. Investors agonized and, in turn, began to yank their money from stock mutual funds. A last-minute deal allowed us to avoid deciding which bills the U.S. Treasury would pay, but it wasn't enough for the U.S to save its pristine "AAA" credit rating.
With more problems unfolding in Europe, some investors cried uncle and sold, exacerbating the whirlwind of volatility, the talk of dire economic outcomes, the market drops, the sharp snapback rallies and the market's hypersensitivity to every bit of news.
Behavioral finance attempts to identify and predict the rational and irrational behavior of investors, who, driven by the emotions of greed and fear, join in the frantic purchasing and sale of financial assets, creating bubbles and crashes.
One area of interest in behavioral finance is "heuristics," rules of thumb in which current behavior is judged to be correct based on how similar it is to past behavior and its outcomes. The idea is that reasons for past behavior still hold true for new situations, so they can be correctly applied again. Heuristics are used to speed up the process of finding a solution when an exhaustive search is impractical. They help us identify "cognitive biases," a general term used to describe distortions in the human mind that are difficult to eliminate and lead to inaccurate judgment or illogical interpretation. Investigations into such biases in investing are based on pioneering research by psychologists Daniel Kahneman and Amos Tversky.