Fishing outside the reef: the illusion of control and finance

Humans regularly see patterns where there are none, but stress makes this tendency worse. Some new studies suggest this may be making the current market troubles worse. Jennifer Whitson and Adam Galinsky (Lacking Control Increases Illusory Pattern Perception, Science 3 October 2008 Vol. 322. no. 5898, pp. 115-117) demonstrated that when people feel they lack control, they see more  illusory patterns in noise and stock market information, perceive conspiracies and accept superstitions more readily. But is this the key to understanding the financial turmoil?

The Science paper is timely, but hardly surprising. That people desire the feeling of control in their lives is universal; people who experience loss of control become depressed, anxious and may lose health. It is not surprising that people are willing to go to great lengths to achieve control, even if it is illusory. This is likely the root of many superstitions. A classic example is from Bronislaw Malinowski, who noted that islanders in the Pacific who fished offshore outside the coral reef had many rituals and ceremonies to ensure safety and protection, while the inshore fishermen were far less superstitious.

Regaining a sense of control, even an illusory one, helps people cope with stress. This may be individually emotionally adaptive, but lead to mistaken decisions. One study found that superstition affects many market decisions (especially under situations of uncertainty) and leads people to pay significantly more for "lucky" products. The Science study found  that participants in a volatile situation formed illusory correlations between infrequent negative information and infrequently mentioned companies, which affected their investment decisions.

But do "illusions drive market havoc" as BBC suggests? That may be another story. The findings in the study are limited and small-scale. There are many other forms of irrationality acting on financial markets. Behavioural finance studies have examined how herding, availability heuristics,  loss aversion affect real markets. Traders are often overconfident in their own information and ignore or reinterpret conflicting information. The sheer amount of potential bias is more than enough to overwhelm the effect of the desire for control – it is just an added complication to a market already affected by biases such as loss aversion.

The true structural reasons for the current financial mess are due to collective irrationality (such as setting up incentive systems for lenders badly and accepting lack of transparency) as well as a natural tendency for financial systems to generate speculative bubbles (something that can occur even when all agents are rational). There is no need to look for particular biases, our bounded rationality is more than enough to cause problems. The particular problems we get and the way they play out, that is shaped by our biases.

Perhaps the most interesting application of the Science paper is to look at remedies. By affirming core values test subjects felt more in control and became less biased.  Similarly many of the proposed financial remedies may be more about societies and governments affirming their core values and showing that they are indeed in control than actually correcting the problem. We should not expect them to solve the underlying financial woes (those will be corrected more slowly and carefully later on, although the corrections will surprise us by their inadequacy at the next and different crisis) but they help people calm down. Financial placebo is the best understood and safest economical medication around.

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