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Stock-Market Psychology
Book reviews / Journal of Socio-Economics 32 (2003) 227–232
229
Stock-Market Psychology Karl-Erik Wärneryd, Edward Elgar; Cheltenham, UK, 2001, 339 pp., $100 (Amazon.com), ISBN 1-84064-736-1 The stock market features prominently in the mass media, and has been the focus of interest of economists for a long time. Psychologists, however, have so far not paid too much attention to the dynamics of the stock market. With his book, Karl-Erik Wärneryd fills this gap in economic psychology. He meticulously brings together existing research and theories on the psychology of investing. Contrasting them with economic theories, he makes a convincing point that psychological and behavioral considerations are important for a better understanding of the market. In his book, Karl-Erik Wärneryd gives a concise overview of the field of stock-market psychology. While reporting both economic and psychological approaches, his focus is on cognitive and affective psychological theories. His book is divided into 10 chapters, starting with a description of financial theories about the stock market that are rationality based. Efficient market hypothesis is described alongside portfolio models based on rational choice and theories about market volatility. In the second chapter, the author reports on modifications of these models that include a behavioral component, e.g. ones that introduce the notion of “noise traders” as opposed to rational or information traders. Noise traders are traders who disturb the efficiency of the market by incorrect expectations, too little diversification, and systematic forecasting errors. In the chapters to follow, the focus shifts to the psychology of the investor. A central concept in Wärneryd’s approach is expectation, which is detailed in chapter 3. He contends that investor behavior is mainly guided by their expectations about future developments, e.g. the returns of a given share or funds. According to his model, these expectations are formed by three main components: extrapolation from earlier experience, learning, and new information. Each component will have a different weight depending on the context, so that the past and the present interact in the formation of expectations about the future. When a person expects a current downward trend to continue, the weight is higher for the extrapolation. When a person expects a current trend to reverse soon, the weight is more on new information. Expectations are crucial for financial success, depending on the correspondence with the future development of the market. Stocks are uncertain investments. They may go up, but they may also lose. So the decision to buy, sell, or hold stocks is fraught with risk, and several decision theories devoted to risky decisions are reported in chapter 4; prospect theory features prominently among them. Further space is devoted to individual risk attitude and risk propensity. Closely connected to the view of “investor behavior” as “investor decision-making behavior” is the main line of the fifth chapter, in which cognitive biases that can occur in decision making are detailed. Starting from the classical heuristics and biases-approach, Wärneryd goes on to current views on heuristics as adaptive and functional. In the next two chapters, the author focuses on those aspects that cannot be well explained within a cognitive framework. Here, he explains how emotional and motivational characteristics of the investor can impact on behavior. Carefully, he distinguishes between market-level “mood” as described frequently in the mass media, and individual moods or
230
Book reviews / Journal of Socio-Economics 32 (2003) 227–232
emotions. Motivation, in particular achievement motivation, and self-control are introduced as psychological concepts that can be useful to distinguish different segments of investors. In the seventh chapter, he discusses social influences on investor behavior. This notion has become popular in the press under the heading of “herd behavior,” but the author points out that there is more to social influence than just blindly following others. Also included here are social learning, subjective causal attributions of the success or failure of others, and information distributed by rumors. The eighth and ninth chapter are devoted to empirical findings from systematic research on investor behavior. Here, the author reports survey studies on individual investors, studies on trading records, and experimental asset markets. While the studies reported here mostly take a general psychology perspective, findings presented in the ninth chapter make a point of individual differences among investors and for the necessity of a market segmentation. Survey studies confirm the idea of large and important differences between investors. In the final chapter, the author reflects on implications of the reported findings, both for research and the private investor. One major point made here is that there is no such thing as a typical investor because of important differences between market segments. Although there are a few highly active traders in every market, a majority can be classified as passive traders—traders who buy and hold. Another major notion put forward is that decisions of investors are based largely on expectations that are formed from several sources and integrated into scenarios—pictures of the future. While scenarios can be helpful in making quick decisions, they are also prone to several biases, and not much is known about how financial scenarios in particular are constructed. Carefully, a section of the final chapter puts together some points that private investors might consider before taking all their money to the stock market. Personally, I really enjoyed this book, in particular the section on social influence, because it opposes the mainstream approach of focusing overly on the individual as the central agent in decision making. I also liked the “rehabilitation” of the common investor, who is frequently disqualified as noise trader by financial theories, but, as the author points out, may indeed have a stabilizing function in the market by not trading too much. I admire Karl-Erik Wärneryd’s work for drawing together the diverse and interdisciplinary literature in such a concise manner. His book will prove an invaluable source of knowledge for scholars and practitioners who would like to have a profound background about the dynamics and the psychology of investors. What sets it apart from other books is its dedication to the complex issues of investor behavior, reporting interdisciplinary scientific findings in a highly precise state-of-the-art format. For economic psychologists and behavioral economists, it is one of those books you have to own. Erik Hoelzl Unit of Economic Psychology, University of Vienna Universitaetsstrasse 7, A-1010 Vienna, Austria Tel.: +43-1-4277-47888; fax: +43-1-4277-47889 E-mail address: [email protected] URL: http://www.univie.ac.at/psychologie/wirtschaftspsychologie doi:10.1016/S1053-5357(03)00018-0
229
Stock-Market Psychology Karl-Erik Wärneryd, Edward Elgar; Cheltenham, UK, 2001, 339 pp., $100 (Amazon.com), ISBN 1-84064-736-1 The stock market features prominently in the mass media, and has been the focus of interest of economists for a long time. Psychologists, however, have so far not paid too much attention to the dynamics of the stock market. With his book, Karl-Erik Wärneryd fills this gap in economic psychology. He meticulously brings together existing research and theories on the psychology of investing. Contrasting them with economic theories, he makes a convincing point that psychological and behavioral considerations are important for a better understanding of the market. In his book, Karl-Erik Wärneryd gives a concise overview of the field of stock-market psychology. While reporting both economic and psychological approaches, his focus is on cognitive and affective psychological theories. His book is divided into 10 chapters, starting with a description of financial theories about the stock market that are rationality based. Efficient market hypothesis is described alongside portfolio models based on rational choice and theories about market volatility. In the second chapter, the author reports on modifications of these models that include a behavioral component, e.g. ones that introduce the notion of “noise traders” as opposed to rational or information traders. Noise traders are traders who disturb the efficiency of the market by incorrect expectations, too little diversification, and systematic forecasting errors. In the chapters to follow, the focus shifts to the psychology of the investor. A central concept in Wärneryd’s approach is expectation, which is detailed in chapter 3. He contends that investor behavior is mainly guided by their expectations about future developments, e.g. the returns of a given share or funds. According to his model, these expectations are formed by three main components: extrapolation from earlier experience, learning, and new information. Each component will have a different weight depending on the context, so that the past and the present interact in the formation of expectations about the future. When a person expects a current downward trend to continue, the weight is higher for the extrapolation. When a person expects a current trend to reverse soon, the weight is more on new information. Expectations are crucial for financial success, depending on the correspondence with the future development of the market. Stocks are uncertain investments. They may go up, but they may also lose. So the decision to buy, sell, or hold stocks is fraught with risk, and several decision theories devoted to risky decisions are reported in chapter 4; prospect theory features prominently among them. Further space is devoted to individual risk attitude and risk propensity. Closely connected to the view of “investor behavior” as “investor decision-making behavior” is the main line of the fifth chapter, in which cognitive biases that can occur in decision making are detailed. Starting from the classical heuristics and biases-approach, Wärneryd goes on to current views on heuristics as adaptive and functional. In the next two chapters, the author focuses on those aspects that cannot be well explained within a cognitive framework. Here, he explains how emotional and motivational characteristics of the investor can impact on behavior. Carefully, he distinguishes between market-level “mood” as described frequently in the mass media, and individual moods or
230
Book reviews / Journal of Socio-Economics 32 (2003) 227–232
emotions. Motivation, in particular achievement motivation, and self-control are introduced as psychological concepts that can be useful to distinguish different segments of investors. In the seventh chapter, he discusses social influences on investor behavior. This notion has become popular in the press under the heading of “herd behavior,” but the author points out that there is more to social influence than just blindly following others. Also included here are social learning, subjective causal attributions of the success or failure of others, and information distributed by rumors. The eighth and ninth chapter are devoted to empirical findings from systematic research on investor behavior. Here, the author reports survey studies on individual investors, studies on trading records, and experimental asset markets. While the studies reported here mostly take a general psychology perspective, findings presented in the ninth chapter make a point of individual differences among investors and for the necessity of a market segmentation. Survey studies confirm the idea of large and important differences between investors. In the final chapter, the author reflects on implications of the reported findings, both for research and the private investor. One major point made here is that there is no such thing as a typical investor because of important differences between market segments. Although there are a few highly active traders in every market, a majority can be classified as passive traders—traders who buy and hold. Another major notion put forward is that decisions of investors are based largely on expectations that are formed from several sources and integrated into scenarios—pictures of the future. While scenarios can be helpful in making quick decisions, they are also prone to several biases, and not much is known about how financial scenarios in particular are constructed. Carefully, a section of the final chapter puts together some points that private investors might consider before taking all their money to the stock market. Personally, I really enjoyed this book, in particular the section on social influence, because it opposes the mainstream approach of focusing overly on the individual as the central agent in decision making. I also liked the “rehabilitation” of the common investor, who is frequently disqualified as noise trader by financial theories, but, as the author points out, may indeed have a stabilizing function in the market by not trading too much. I admire Karl-Erik Wärneryd’s work for drawing together the diverse and interdisciplinary literature in such a concise manner. His book will prove an invaluable source of knowledge for scholars and practitioners who would like to have a profound background about the dynamics and the psychology of investors. What sets it apart from other books is its dedication to the complex issues of investor behavior, reporting interdisciplinary scientific findings in a highly precise state-of-the-art format. For economic psychologists and behavioral economists, it is one of those books you have to own. Erik Hoelzl Unit of Economic Psychology, University of Vienna Universitaetsstrasse 7, A-1010 Vienna, Austria Tel.: +43-1-4277-47888; fax: +43-1-4277-47889 E-mail address: [email protected] URL: http://www.univie.ac.at/psychologie/wirtschaftspsychologie doi:10.1016/S1053-5357(03)00018-0