The news regarding the ongoing problems in our financial systems, analysis and second-guessing of those news, and prescriptions for or against proposed ways to right the ship (AKA the Bailout/Rescue package) have reached a fevered pitch.

Rather than add to this imbroglio, I’ve decided to "take a time out" (though I’ll admit I have been an avid participant in debates on various related blogs over the last few weeks to keep on top of this), and focus solely on the psychological aspects of all this. Things that should largely be beyond the realm of political and economical opinion (I am not an economics expert, nor do I believe that infusing politics into this is helpful at this point).

To borrow a well-worn metaphor, if you cannot see the forest for the trees, maybe you can at least create some clarity for yourself as to what types of trees you are dealing with:

1) The fractional reserve banking system that most of the world has used for many decades is fundamentally based on confidence and trust between the parties involved. That is what we mean when we use phrases such as "the full faith and credit of the U.S. goverment".

Since the Bear Stearns "forced sale" in March, trust has been evaporating at ever faster rates. So much so that at this point, nobody trusts their counter-parties anymore, and hoards cash positions wherever they can.

2) In the absence of confidence and trust, there is only fear and uncertainty. Fear tends to attract more fear, such that there is a tendency to become a self-fulfilling prophesy. Hence the words we use and think do matter.

You see, terms such as "melt-down, toxic assets, fire sale, depression, collapse," asf. all have a tendency to incite further fear, because they draw on metaphors of real and direct physical harm rather than the hardly comprehensible yet comparatively boring transfer of blips of numbers on computer screens and piles of paper between various complex corporate entities (themselves largely purely abstract and based on further piles of paper).

After initially due to form going overboard with such language, the mainstream media has now largely pulled back from its usage, after apparently scaring ITSELF with the precipitous stock market "dives" last week.

Lesson: I would advise you to do the same. Stop using misleading and inflammatory language for the sake of your own sanity during a time of challenge.

3) Back to the issue of trust, since it is a purely psychological state, all elements of long term forming of associations in our mental real estate – in other words "branding" – come into play. The best example of this I could find is the fact that last week, the brand of "Warren Buffett" – shrewd yet kindly investor and economic wise man, the "Oracle of Omaha" – commanded a tidy premium when lending money to Goldman Sachs and General Electric well beyond that which the U.S. government would charge.

In other words, Warren Buffett has built up a brand that made him more trustworthy in the minds of many than even the "full faith and credit" of the U.S. government. Now while this is of course illogical on its face, it is nevertheless true at a deeper psychological level:

The inherent endorsement those two companies got from having Buffett invest a total of about $8 Billion was worth the premium to them, given his well-known penchant for strict value investing and abhorrence of leverage (investing with borrowed money). It was somewhat like say Michael Jordan endorsing Wheaties.

Lesson: Continue to build your own brand as a haven of sober analysis, rational balance, and calm, in ANY interaction with customers, clients, and even just your friends and family. You simply can’t go wrong.

4) Being reminded of prior warnings by Buffett against an impending housing bubble, let’s quickly look as to how this sort of thing can develop (and repeatedly so). Why would otherwise supposedly largely rational people act in ways that would turn out to be so problematic, even ruinous longer-term?

The answer is twofold: First, there is denial.

It is considered one of the nearly inevitable responses that occur in the so-called "Five Stages of Grief" in situations involving any kind of loss. While first conceived regarding the loss of the "dearly departed", it was soon realized that the stages apply to losses such as divorce, loss of job, and even what I like to call "merely cherished ideas".

Such that once an asset bubble like the run-away housing market is forming, the time from the first warning signs and occasional warning messengers to acceptance of the new reality is greatly expanded because of denial. When things were going so well, nobody wanted to start to think that their homes were not going to be ever-appreciating, supposedly almost risk-less assets anymore.

The truth is, everyone becomes complicit: Buyers (both "regular", as well as "investors" AKA flippers), realtors, appraisers, mortgage brokers, bankers, derivative creators, the Fed, the government, asf. When you mentioned "price-to-rent ratios" circa 2005, people would look at you askance and practically call you an unpatriotic nay-sayer.

I saw the same thing shortly before the 2000 Dotcom bubble bursting: Working at a Telecom company at the time, I remember a supervisor of mine saying something like – "If anyone is taking their yearly bonus in any form other than company stock options, they are simply goofy…".

People hate to let go off cherished ideas, no matter how mistaken or irrational they may be.

Lesson: Learn to detect denial as quickly as possible, and then move trough it.

5) The second cause is what is called "relativity" in behavioral economics. People not only want what is best for them in a purely rational sense, they want what is best relative to everyone else (primarily their peer group) due to the value placed on status within a group. So we get a social-status-cum-economics heuristics (this is sometimes called "neuro-economics"):

In one study, 56 percent of participants preferred a job paying $50,000 per year while everyone else earned $25,000, rather than a job paying $100,000 per year while others made $200,000 – forgoing $50,000 per year simply to maintain a position of relative affluence. Other similar studies have showed much the same thing.

If everyone else seems to be making a presumptive killing in the housing market, we want to be in on the deal, even if it doesn’t make economic sense anymore (that’s where those price-to-rent multiples come into play, they could have told you pretty reliably).

Lesson: Forget what everyone else is doing. "Social proof" is rarely any sort of proof at all, because by rule of the 80/20 Principle, the vast majority of people tend to be doing things wrong, or at least inefficiently/ineffectively.

6) Once denial and other distorting effects have worn off, and the truth is staring us in the face, yet another psychological dynamic takes over. Similar to the second of the Five Stages of Grief, Anger, we find a tendency toward scapegoating.

Scapegoating is an ancient ritual founded in the agreed-upon sacrifice of one (or a few) member(s) of the tribe, for the good of the (mental health of) all, by means of a form of catharsis.

In our case, pretty much the entire nation should be mad at itself, but people individually tend not to like to do this for longer than a moment. Instead "scapegoatism" of what are mostly red herrings is the order of the day: Short sellers did it, minority "sub-prime" borrowers and their HUD enablers did it, a handful of greedy Wall Street CEO’s did it, rocket surgeon wizards creating incomprehensible financial derivatives did it, etc.

As I said, I don’t wish to inject politics into this post, so I am not going to argue about the relative weightedness of any of the above-mentioned possible contributing factors (though I have seen very persuasive evidence that short sellers and minority sub-prime borrowers had overall very little to do with it). But the simple truth is that there were many causes.

Yet we have a reflexive aversion to thinking less of ourselves, and thus may feel compelled to find a convenient stand-in.

In closing, I hope you found this elucidating. FDR was likely right in saying that "we have nothing to fear [more] than fear itself." My instinct is to say that, if we take more control of our own often less-than-rational mental processes, think things through, and act with decency and good will towards our fellow (wo)man, this too shall pass.

We will get through these "interesting times."

63 thoughts on “Psychological Aspects of the Financial Crisis: In Warren Buffett We Trust?

  1. I fully agreed with you Alex, the greatest enemy is always ourselves.

    I have just completed reading the book “The Winning Investment Habits of Warren Buffett & George Soros” which have highlighted that both gurus followed their own system religiously, refusing to let emotion and market situation affect their decisions, and this is the main reason they can outperform the market and emerge as the winner going through so many ups and downs in the market!

    But it takes a tremendous amount of discipline to listen to the rational side of your brain and stick to your original plan even though your heart is screaming for some adrenaline change!! In fact, it takes lots of mental training before you can be sure that you can trust yourself!!

    I guess that is the nature’s way to separate the Greats from the rest.. good news is, discipline can be trained!

    Cheers!

  2. Keep in mind that Warren Buffet still lives in the same house he grew up in.

Comments are closed.