There is no doubt that the financial crisis of 2008 and the subsequent deep recession left psychological and emotional scars on investors. 2011 brought many of the fears and anxieties back. Even though we are more than three years removed from the depth of the crisis, lately it doesn't seem to take much for investors to panic and head for the exits. We have been witness to, and sometimes participants in, "information cascades." This cognitive bias is the tendency to ignore our own objective information or private insights and instead focus on emulating the actions of others. Michael Mauboussin of Legg Mason Capital Management points out in his book More Than You Know that the stock market has no defined outcome and no defined time horizon, so it's the prices in the financial market that both inform its participants about the future and influence decisions. Efficiency is lost when investors imitate one another or when they rely on the same "information cascades." These induce market players to take the same course of action (buy or sell) based on the same signals from the environment, without consideration that others are doing likewise (or that it may be in the best interest of the player to refrain from taking the same action).
In some sense, information cascades are related to herd behavior, exacerbated during periods of extreme negative sentiment. "That unintended system-level consequences arise from even the best-intentioned individual-level actions has long been recognized," Mauboussin writes in his second book, Think Twice. "But the decision-making challenge remains for a couple of reasons. First, our modern world has more interconnected systems than before. So we encounter these systems with greater frequency and, most likely, with greater consequence. Second, we still attempt to cure problems in complex systems with a naïve understanding of cause and effect."
Recently, Mohamed El-Erian, the co-chief investment officer at PIMCO, opined in The Huffington Post, "In such environments, market liquidity becomes more elusive, counterparty risk concerns mount and certain investors turn into distressed sellers. As illustrated in the 2008 global financial market meltdown, these issues can become disruptive in themselves, fueling a chaotic economic and technical deleveraging process." If these feedback loops don't flame out on their own, they can do real harm to the "real" economy by persuading people to postpone or cancel spending that was rational before the feedback started.
Feedback loops involving investor confidence occur in the context of a complex social and psychological environment. Robert Shiller stated in his famous book Irrational Exuberance that feedback loops are a vicious circle.
"Underlying this feedback is a widespread public misperception about the importance of speculative thinking in our economy. People are accustomed to thinking that there is a basic state of health of the economy, and that when the stock market goes up, or when GDP goes up, or when corporate profits go up, it means that the economy is healthier," Shiller wrote. "It seems as if people often think that the economy is struck by some exogenous maladies, and that the stock market is just a reflection of those shocks. But people do not seem to perceive how often it is their own psychology, as part of a complex pattern of feedback, that is driving the economy."
While asset price bubbles represent one set of challenges, it is during times of negative feedback cycles that restraint and thoughtfulness must prevail. Merton concluded that the only way to break the cycle is to redefine the propositions on which the false assumptions were originally based.
The world is an unsettled place; the future course of events is not predictable with enough precision to prevent further information cascades, negative feedback loops or self-fulfilling prophecies. Things can change quickly. Rumors seem to morph into reality, while sanity and common sense take a back seat to catastrophizing. During these times, the best thing you can do is recognize and manage your emotions and impulses and keep your investing plan intact. If you are a financial advisor, these are the times where you earn your pay. Your clients will need emotion and impulse management as well. It may be during those occasions that we step back, take a deep breath and think through our actions and the consequences.
Whether the remainder of 2012 will bring about the kinds of unexpected surprises we experienced in 2011 is unknown. Having a better awareness of our human biases can certainly help us navigate uncharted waters.
Martin E. Landry, CFA, CFP, CAIA, CIMA, CIPM, is an investment due diligence analyst for 1st Global Capital Corp.