The psychology of money part two — the speculative episode

by Cameron Stockman

10 August 2011

In the second of his three-part series, Stockman examines the psychology of the markets. (Photo supplied).

Bankers, policy makers, and investors are still dealing with the paradigm shift that the “great recession” of 2008-09 imposed upon most of the economies and politics of the industrialized nations around the world. In dealing with the aftermath of one of the most serious and systemic crises our modern world economy has faced, we’ve seen the struggle to de-leverage continue through many large financial institutions, and now expand to many domestic governments. This process of adjustment to the new global financial environment has led many governments to begin a process of regulation, enacting legislation both global and domestic in scope in an attempt to limit or interpret the kind of activity that could cause another global systemic breakdown of credit and confidence.

Repercussions that erupted from the great recession have been swift and ground-breaking, changing the status-quo of banking limitations and financier accountability. Supporters of legislation like the Frank-Dodd act in the United States, and the international accord Basel 3, believed that lack of regulation in the financial sector was a main prerequisite for the failure of the system. In some ways they’re correct, the lack of a strong regulatory body and harmonized legislation allowed for the creation of strong regulatory arbitrage between countries. However, placing the blame primarily on this one issue disregards many other “perfect storm” factors, that in combination allowed for a strong systemic failure of the banking and financial system. As in most crises, blame has been thrown about in many directions attempting to find a scapegoat so the rest of the system can escape without any question. As regulation has become the focal point of re-shaping our financial system, we’ve missed the opportunity to take a real look at the incentives and basic human behaviour that’s driven the world economy of the railroad tracks more that once before.

At its most basic level, the financial sector is a system that places the prize on profit, relative gain at the expense of others, and created a complex moral hazard effect that has rewarded entire corporations for taking unwarranted risk. However, this system has created the most powerful incentive structure on earth, providing motivation that the back of human welfare has been carried upon throughout its period of dominance in the twentieth and twenty-first century. It’s this incentive structure that I wish to discuss, and its innate interaction with the marketplace that has created the perfect environment for something we can now call the “speculative episode” to take place. In accordance with my previous instalment of this series, this article will focus on the psychology behind speculation, and how the alterations of human behaviour—and more directly expectations—have the ability to deviate any one asset, and in some cases the entire market away from its proper functioning.

Speculation is the act of causing asset prices to deviate from what we can call their “fundamentals.” “The speculative episode” is the ability for asset price speculation to have a transmission effect between other asset prices, causing the proliferation of toxicity through the entire system and creating an environment ripe of systemic risk. However, before explaining this transmission mechanism, it’s important to know what definition we will use as the asset prices fundamental value. Although there are other, more complex, and technical methods to find an assets value, essentially an asset price reflects the present value of any expected stream of income coming from its ownership, as well as its expected future sale price. For example, in considering a stock, we would be considering the P.V. of its expected future dividends, as well as its expected capital gain or loss at its sale. As changes in expectations regarding the future sale price of a stock are the most volatile, that biggest determinant in speculation. Speculation on the movement of an asset price augments the current asset price to reflect their expectations.

If these inflated expectations occur in the right number, and by the right amount, they create the power to disassociate current asset prices from their true basic value. This separation is known as an asset bubble, an inflated expectation of future value that creates nominal prices to be far different from what they are actually worth. However, as long as these expectations remain in place, asset bubbles cannot be altered until the marketplace reverses their expectation. In my previous instalment of the Psychology of Money series, we discussed herding behaviour between investors, and how expectations may cause exit en masse in the marketplace, prompting investors to act upon emotion rather than on rational fundamental analysis. In this case, we have a similar situation in which investors with enough inflated expectations can influence other investors to follow their lead in assuming higher asset prices, causing more frequent and severe asset bubbles to be created.

The first act of speculation has the ability to create an intensifying spiral of speculation that gains momentum and force as more and more join it, creating exponentially upward-moving prices. As this “speculative episode” takes off under its own, more speculation begins, asset prices rise, creating ever-greater new found optimism in future sale prices. As investors’ expectations of rising prices augments what current price they believe their asset is worth, the change in the current asset price in the marketplace justifies their initial optimism. As this process continues, a self-fulfilling prophecy is created. Prices rise, capital gains are realized by those invested in the assets, and the speculative optimism supporting the process has incentive to continue. The inflation of an asset and potentially an entire marketplace will continue to rise, until the justification of one’s initial investment is no longer supported by the optimism upon which it grew.

As we’ve seen, it is not the initial process that pushes the system into crises, it’s the exit strategy and the consequent unravelling of asset prices that have the potential to spell complete systemic disaster. Although the gains realized in this process are real, and potentially can support extended bull-runs and massive capital gains for investors alike, when the process runs out of momentum the floor has the capacity to fall from under the entire market. In a process of speculation that’s been maintained for some time, with the introduction of any doubt into gains realized, expectations have the capacity to reverse completely. As expectations begin to reverse, current asset prices begin the fall to reflect the doubt that’s been placed into the system affecting the expected future sale price of an asset. Where these expectations end no one knows, but this unravelling process has the capacity to dissolve any and all gains realized through the cycle of speculation.

Throughout history, we have seen many instances of this sort of speculation. Speculation is an integrated part of human behaviour that needs to be understood, and not ignored by placing blame upon the system that it affects. As we look forward to what answers we may come up with to try and support the financial system on which we rely so heavily upon, we have to attempt to look at the deeper problem of trying to change our behaviour to limit the squander and excess that’s continued to follow us. Although regulation has the capacity to shore up the system, if we fail to understand the inner workings of how our system interacts with human behaviour, we are fighting a losing battle.

This is the second part of an exclusive three-part series that will be examining the Psychology of Money. The first part can be found here.

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The psychology of money part two — the speculative episode

by Cameron Stockman

10 August 2011