The study of financial markets without use of psychological tools can be dull; "adding psychology offers some fascinating insights," said Assistant Professor of Economics Sendhil Mullainathan in a January 19 Spark Forum talk, "The Psychology of Financial Markets."
In the beginning were "chartists -- guys in the 1930s and 1940s who looked at patterns in prices and made trades" based on those curves, he said. No psychology applied. The 1950s and 1960s brought the theory of efficient markets and the practice of arbitrage. Still, no psychology applied; "weird patterns could be arbitraged into submission."
But psychology can dramatically affect how people behave in relation to financial markets, and it may help predict how markets will behave, Professor Mullainathan said. "People are remarkably overconfident. They trust their own judgment way too much. They get overly excited about recent good performance. They have loss aversion and will even take risks to avoid selling. Not wanting to face the pain of realizing a loss, people hold onto losers too long and sell winners too quickly."
His advice to a friend with plenty of money to invest? "Whatever you do, don't trade. Individuals trading on their own actively underperform," he said, advocating investment through a fund manager.
"So how do we make money in the market?" he asked. The answer, he suggested, is to be less vulnerable to, well, human psychology.
A version of this article appeared in MIT Tech Talk on January 26, 2000.