The power of self-fulfilling stories in financial markets

26 02 2010

Soros, the new Citizen Kane? (Credits: mindfully.org)

On December 2009, the euro traded at $1.51. Today, it trades at $1.35. What can explain this 11% downfall in little bit more than 2 months? An avid reader of the Wall Street Journal or the Financial Times will eloquently explain that it just reflects the faster recovery of the US economy out of the crisis vs. Europe, amplified by fears that Greece may default on its sovereign debt. End of story? Not so fast. A closer look will reveal the perfect case study for the power of self-fulfilling stories in financial markets.

Deeply ingrained in our collective subconscious is the fear that we are getting manipulated by higher forces. Not so long ago, people questioned the power of mass media and how Rupert Murdoch or Silvio Berlusconi could bend reality with their editorial lines rather than reporting it. I will argue that hedge fund managers and other leading investment bankers have become the new Citizen Kane, shaping reality with powerful storytelling. Financial markets have slowly but surely built a very advanced language that now allow them to communicate and broadcast complex stories. Puts, call, credit-default swaps and other derivatives constitute the building blocks of their vocabulary. Traders have become the journalists that put those words together, following the editorial line dictated by their fund manager. The assets under management, the equivalent of circulation, provide more or less clout to the fund editorial line. Read the rest of this entry »

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The predicted extinction of the Homo Economicus

19 02 2010

Source: hugsandi.is

Amongst fear of biodiversity loss, one species is slowly but surely facing extinction – the Homo Economicus. According to Wikipedia, the Homo Economicus “is the concept in some economic theories of humans as rational and broadly self-interested actors who have the ability to make judgments towards their subjectively defined ends.”

Yes, human beings are capable of rational and utilitarian thinking but this is only the tip of the iceberg. Neuroscience has made tremendous progresses on how our rational and irrational selves interact but there is still a long way to go. For a curious reader, I recommend the book “How we decide” from Jonah Lehrer. In this book, Lehrer provides plethora of scientific nitbits that will challenge your beliefs about the human brain. For instance, we are all victims of a phenomenon called “anchoring” or how your short-term memory strongly influences your most “rational” decisions. A group of economists led by Dan Ariely asked MIT students to enter an auction and bid on several random items ranging from a cordless keyboard to a bottle of wine. Before bidding for each object, students had to write down the last two digits of their Social Security Number and decide whether they were willing to pay that numerical amount for the item. Then, they were asked to place their final bid for the object. It turned out that students with a higher-ending Social Security Number made an average bid 4 times greater than the ones with a lower-ending Social Security Number. While their Social Security Number was irrelevant to bid for a cordless keyboard, their brain kept the information in their short-term memory, which anchored their next decision. Read the rest of this entry »