Volume 2, Number 3, 2001 Abstracts
© Copyright Erlbaum 2000 & 2001

Unconscious Herding Behavior as the Psychological Basis of Financial Market Trends and Patterns
Robert R. Prechter, Jr.

Human herding behavior results from impulsive mental activity in individuals responding to signals from the behavior of others. Impulsive thought originates in the basal ganglia and limbic system. In emotionally charged situations, the limbic system's impulses are typically faster than rational reflection performed by the neocortex. Experiments with a small number of naïve individuals as well as statistics reflecting the behavior of large groups of financial professionals provide evidence of herding behavior. Herding behavior, while appropriate in some primitive life-threatening situations, is inappropriate and counter-productive to success in financial situations. Unconscious impulses that evolved in order to attain positive values and avoid negative values spur herding behavior, making rational independence extremely difficult to exercise in group settings. A negative feedback loop develops because stress increases impulsive mental activity, and impulsive mental activity in financial situations, by inducing failure, increases stress. The interaction of many minds in a collective setting produces super-organic behavior that is patterned according to the survival-related functions of the primitive portions of the brain. As long as the human mind comprises the triune construction and its functions, patterns of herding behavior will remain immutable.

A Report on the March 2001 Investor Sentiment Survey
David Dreman
Stephen Johnson
Donald MacGregor
Paul Slovic

Steep declines in the value of publicly traded stocks in the first quarter of 2001 left many market observers speculating whether investor sentiment had undergone a significant and negative change, and whether investors would subsequently flee stocks in favor of less volatile investment options. A survey study of investor expectations and confidence was conducted in late March 2001 to capture investor sentiment and compare it with similar measures taken in surveys conducted in 1998 during a period of rapid market incline. The surprising results are that there are only minor differences in investor sentiment in terms of: (a) confidence in the long and intermediate performance of the stock markets; (b) composition of stocks versus bonds in their portfolios; (c) the intention to buy on the dips; (d) the amount of risk investors plan to undertake. The high level of investor confidence observed in 2001 (in spite of a severe drop in market value) is potentially accounted for by psychological processes that influence investor judgment. These processes include reliance on image-driven affective evaluations of common stocks that contribute to excessive optimism.

A Behavioral Model of Stock Market Investors' Impact on Consumption
Samuel B. Bulmash

This paper offers a theory of investor/consumer behavior in the context of an adaptive relationship. It shows how consumer spending and stock market gains and losses interact in a "gradual diffusion" process. The model offers predictions about likely changes in investor behavior, and the impact on the underlying economy in general and consumption in particular. These predictions are validated empirically. Specifically, the paper finds that investors/consumers gradually smooth their "wealth spending" and accelerate consumption as they become more convinced that their gains are permanent.

This is somewhat reminiscent of the "income smoothing" suggested by Friedman [1957]. We present evidence that the consumption wealth spending peaks at approximately 2.5%—3% of the stock market wealth cumulative gain in the previous twelve- to twenty-four-month period, while concurrent effects are negligible. The results also provide a partial explanation for the long cycle of a strong economy in the 1990s, and point out the danger to the economy from a prolonged stock market decline.

On Ignorance, Intuition, and Investing: A Bear Market Test of the Recognition Heuristic
Michael Boyd

This study replicates recent tests of the recognition heuristic as a device for selecting stock portfolios. The heuristic represents a lower limit to the search for information, since simple name recognition is the least one can know about anything. Gigerenzer and others conducted original experiments in this field at the Max Planck Institute for Psychological Research's Center for Adaptive Behavior and Cognition (the "ABC Research Group"). The ABC Group's tests support the use of the heuristic in a bull market environment. This study, conducted in a down market, reaches a different conclusion: Not only can a high degree of company name recognition lead to disappointing investment results in a bear market, it can also be beat by pure ignorance. Virtually the only finding of the ABC Group's study that we match here is that Americans are not very good at picking American stocks to outperform the market.