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Dean Blount's Blog
  Bob McDonald
  Bob McDonald is the Erwin P. Nemmers Professor of Finance.
   

Volatility and Psychology
August 15, 2011

The one thing that all of the economists I know agree upon is that we are in an era of increased market volatility. The errant notion of the “great moderation” has long passed. We all have deeper respect for the interconnectedness and uncertainty that comes from the markets, currencies, political turmoil and daily lives of the nearly 7 billion sentient beings who now occupy our world. On a simple numbers level, humanity confronts more complexity and uncertainty every day with each uptick in the world population.

But why all of the volatility?

Did the world change that dramatically over the weekend of August 6 and 7? Early last week, as the media was harping on how the S&P downgrade was causing turmoil in the markets, I found myself increasingly frustrated. From an economic theory perspective, I know that no new relevant information was communicated by the downgrade; nothing new had happened economically. My sense instead was that the turmoil was psychologically driven.

Bob McDonald, Erwin P. Nemmers Professor of Finance, agreed with me. He noted, “The S&P downgrade rationally should not have been a big event because a) it was already obvious that U.S. budget politics are a mess, b) the S&P doesn't have any special advantage in figuring out the vagaries of U.S. politics or even in doing budget calculations, and c) it was expected, given the budget compromise and S&P’s earlier statements. Employment news continues to be disappointing.”  None of this was a surprise.

Torben Andersen, the Nathan S. and Mary P. Sharp Professor of Finance, added, “There are various serious concerns out there and the stream of negative news has intensified lately. Hence, there is some reason behind the dramatic moves. However, it is hard to rationalize the extent of the drops unless one says that it reflects a consensus that the likelihood of a global recession has gone from very small to large. But it’s not clear that most observers are quite ready to say that.”

 

Torben Andersen  
Torben Andersen is the Nathan S. and Mary P. Sharp Professor of Finance.  

The psychology of being human

So I’m back to my original conclusion. The extreme volatility in the markets demonstrates an important psychological component within the marketplace. The internal jitteriness that comes from facing uncertainty, unpredictability and a sense that no one really seems to know the future is real. We all feel vulnerable when we see riots in London, watch several western European economies teetering on collapse, and witness the irrationalities of how our own U.S. government and their electorates seem to make decisions.

Indeed, these are grave and uncertain times, and I wish that humans really were the “rational actors” that old-line economic models assumed. Not only might that help settle our nerves, but it might improve our behavior.

We might all try pitching in to stop the market churn. That’s why education is so important — especially business education. It makes us all a bit more rational about organizations and markets. We’re more able to separate stories, hype and our visceral emotional reactions from the reality of the fundamentals that drive economic growth, job creation and market recovery.

Education also reminds us about history and that these cycles are a part of being human. With emerging research insights on the human condition, we can and will find the means to solve current dilemmas. One way or another, the sun will come out tomorrow, and the markets will someday rise again...

I welcome your comments, feedback and ideas at sallyblount@kellogg.northwestern.edu

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