You can?t predict the next financial crisis if you think the Irish have red hair

This was a question co-authors Nicola Gennailoi, Andrei Shleifer and Robert Vishny deigned to pose in their latest research. 

They said: ?In standard economic theory financial crises are seen as market responses to catastrophic but very unlikely events, sometimes referred to as black swans. Historically, however, financial crises have occurred quite often, particularly after periods of prolonged debt growth. How can crises be at the same time systematic and yet catch investors by surprise??

The answer, it seems, is due to the psychology of investor beliefs ? and to the mechanism of representativeness.

“We model representativeness as inducing people to overestimate the probability of outcomes that are only relatively more likely,” Gennaioli explained. “For instance, why do we think that many Irishmen are red-haired? The reason is that red hair is more common among the Irish than among other people. While only one-hundredth of the world population is red-haired, one tenth of the Irish population is. In absolute terms, red hair is uncommon among the Irish too, but we make a mistake because we mix up relative and absolute numerosity.”

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This research ? the first of a set of studies that will look at the role of investor psychology ? served to highlight that investor intuition naturally yields boom-bust financial cycles. For example: after a series of good financial news the probability of other good news is overestimated, leading to investors becoming optimistic and increasing debt. 

Intermixed bad news does little in terms of changing investors’ mood because good outcomes still seem more likely. Debt will then continue to grow despite early warnings, the authors said. But when a string of bad news occurs, the bad outcome becomes sufficiently more likely that the representative scenario changes from boom to bust, leading investors to overreact.

“Bad news episodes,” the research claimed, “are dangerous because they very quickly change representation, not because of the objective (and unlikely) consequences they bring about.”

Financial crises can thus be systematic and yet catch markets by surprise because investors overreact to the then recent good news and fail to recognise the similarities among the different pre-crisis bubbles. 

Of this, Gennaioli explained: “Financial innovation is in principle desirable, but it can lead to bad outcomes if psychological factors cause investors to neglect the risks of new securities. Financial authorities, moreover, should certainly promote financial literacy policies, but they should also pay attention to increasingly available data on the systematic errors embodied in investor beliefs. This data may help monetary policy to stabilise markets against the vagaries of investor sentiment.”

“Never let a good crisis go to waste” has been attributed to Winston Churchill in reference to the conditions post the Second World War that allowed for the formation of the United Nations. It of course refers to the peculiar environment that surrounds people in the midst of a crisis where somehow all paradigms seem up for debate and rules are to be questioned.

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