Cognitive psychologists have identified numerous emotional biases that distort our thinking when we are feeling stress.  These biases have self-explanatory names such "black-and-white thinking", "over-generalization'", and "catastrophizing."  Catastrophizing is the bias I'd like to use to illustrate what is happening to the thinking of the European public.  Catastrophizing refers to overestimating the odds of severely negative events happening.

Catastrophic thinking has its roots in our genes and neurochemistry.  Think about it:  it was better that our ancestors over-estimated the odds of a disaster than underestimated.  They would have been culled from the gene pool if they were under-prepared for potential danger, if it actually struck.  As a result, we are descended from "Nervous Nellies."  We are hardwired to think the worst in dangerous situations.

The most apparent example of catastrophization occurs in the way we estimate probabilities of unlikely, but potentially severe, events.  The image below depicts our overestimation of small probability negative events.  "Affect-rich" refers to the odds we place on events that have vivid and emotional signs, like riots and burning buildings in Greece.  "Affect-poor" refers to the odds we place on objective, boring events, like the chance the next Euro notes will have a picture of the Copenhagen-Malmo (Øresund) Bridge.  As the curved line deviates above the straight diagonal line, it represents the increase in estimated probability above the actual level for Affect-Rich (high emotion) events.  Affect-Poor events are also overestimated, but less so.

SOURCE:  Image adapted from Hsee and Rottenstreich: "Music, Pandas, and Muggers: On the Affective Psychology of Value" (2004).

Fortunately, we do not have to be passive victims of our own catastrophizing.  Cognitive psychologists have found that we can consciously supplant anxious thoughts with unbiased and objective thoughts, thus reducing the core emotion - anxiety - and interrupting the positive feedback loop and mental "spinning" that anxiety causes.  Consciously thinking unbiased thoughts acts to calm anxiety, and thus we can intentionally modify our thoughts via cognitive therapy techniques, reducing biases such as catastrophizing.

In the case of Greece and the Euro-zone, it's important to keep this in mind as the crisis intensifies.  We are all emotionally primed to feel anxious by the media.  As investors, however, it is key to remain objective (and contrary) about the herds' emotion.  The best way to remain objective is to consider the cognitive processes that have already and that will unfold among European leaders, voters, and investors.  The four Researcher's Corner sections below articulate findings that shed light on how humans repeatedly get into bad financial situations through short-term thinking, why we "kick the can down the road" to avoid short-term pain while risking longer-term disaster, and how a final capitulation occurs. 

This May Harvard behavioral economist David Laibson gave a fascinating talk at UCLA about some of his latest behavioral research.  Dr. Laibson is well-known academically for adapting a hyperbolic discounting model (the beta/delta model) to describe how people make saving, spending, and investing choices.  He's also done terrific work on cognitive decline and financial decision making, which we cite in our MEMRI script for financial advisors. 

In his recent UCLA talk, Dr. Laibson described research he performed with John Beshears (of Stanford) and colleagues.  They tested a model of savings in which subjects were given a choice of a "liquid" savings account (they can withdraw money at any time) versus a savings account with an early-withdrawal penalty.  After one year, the subjects who kept their money in either savings account would receive the original savings plus a 22% return.  The researchers tested several combinations of punishments for the early-withdrawal condition.  Some could choose to receive their experimental earnings either in the freely liquid account or in the one with a 10% early-withdrawal penalty.  Another group could choose between the liquid account and an account with a 20% early-withdrawal penalty.  A third group chose between the liquid account and an account with no ability to withdraw funds until the year was up (a lock-up account).  Remember, the subjects received a 22% annual return on their savings in whichever account they chose. 

Rational expectations theory assumes that people have perfect self-control, and as a result they should choose the fully liquid account option (in case of an emergency or a higher available return, they could then withdraw the saved money for that purpose).  Contrary to rational theory, many people chose to use the penalty-accounts with the percentage choosing the penalty accounts increasing as the potential penalty increased.  More than 20% of subjects chose the 10% penalty account in the first group.  In the second group more than 30% of subjects the 20% penalty account, and in the no-withdrawal condition more than 50% of subjects chose this account for their savings versus the liquid account.  Many people voluntarily chose future punishment in case they withdrew their money early.  Technically speaking, people will chose the threat of punishment against their future selves in order to enforce self-control on them.

Psychologist Daniel Kahneman shared the 2002 Nobel Prize in Economics for his development of Prospect Theory with Amos Tversky.  Prospect Theory is a model of decision-making under risk, based on experimental evidence (in contrast to most economic theories), that describes how people decide when faced with potentially negative outcomes (risk).

It turns out that people behave very differently depending on their "reference points" (essentially, their expectations).  For example, when people are in a bad situation, and they have hope of recovering via perseverance, they generally INCREASE their risk-taking.   This increase in risk-taking is also called "doubling-down" and is driven by what Hersh Shefrin and Meir Statman called the disposition effect (a.k.a. "breakeven-itis" - the desire to get back to a neutral position).  This is the psychological process that drives that bane of traders, "holding onto losers too long."  Holding onto losing positions too long (in the form of "throwing good money after bad" and the "sunk cost" bias) is also a scourge of taxpayers and is seen in expensive never-ending over-budget military projects like the "stealth bomber" and infrastructure projects like "the Big Dig" in Boston.

The Euro-zone has so far thrown tens of billions of good money to Greece (and now $125 billion to Spanish banks) with the hope that after receiving this money, Greece would reform.  Greece not only did little to reform its tax code or pensions system, but also many Greek voters spurned the bail-out, labelling it German imperialism.  Europeans might justifiably feel a bit angry by the intransigence of the Greek government.  And it is this anger, as it gives way to hopelessness, that will reset the European reference point (expectations) from hope to despair - from potential recovery in Greece, to Greece as a lost cause.

Neuroscientist Wolfram Schultz demonstrated that our brain's learning mechanism is fueled by one of the brain's dopamine circuits (the meso-limbic, which runs through the reward system).  Interestingly, this system is most responsive to expectations (the reference point).  When expectations are increased by rumors or potential positive events, a surge of dopamine is released.  When the expected event happens, if it is in line with expectations, then the dopamine level does not change.

When rumors of a Spanish bank bail-out hit the news, world financial markets rallied and finished last week as their best week of 2012.  The reward systems of traders were excited by the anticipation of some relief.  After the Spanish bank bailout was announced, European markets gapped up on the good news but ultimately sold off, down more than 1% for the S&P 500 by end-of-day.  So what happened?

When positive expectations are met (or worse, disappointed), then the dopamine system deactivates, leading to decreased dopamine activity and decreased risk taking.  In the case of traders, such deactivation from calmed expectations leads to selling.

Below are Schultz' images of how the brain's dopamine neurons in the reward system respond to rewards ("Reward") and how they respond when expectation of reward are set ("Stimulus").  Notice that the frequency of dopamine neuron firing increases in the second image when the stimulus is received (and expectations are set), but decreases very slightly when an expected reward is received.  Dopamine firing pauses entirely in the third image when the expected reward is not received ("no reward").

SOURCE:  Schultz, W.  2011.  "Potential Vulnerabilities of Neuronal Reward, Risk, and Decision Mechanisms to Addictive Drugs." 

Schultz' work is relevant to the Euro crisis because it can trace much of the price volatility to the fear of disaster, then expectations of short-term salvation (saving the Spanish banks), then disappointment when expectations are met (or disappointed), and finally the next crisis looming into view.  When Euro-zone leaders meet, expectation (and hope) is high that they will present a coherent plan.  When they do not present a workable plan, markets plummet.  Sometimes European leaders surprise with temporary relief measures, and the markets rally for a few months until it again becomes clear that Euro-zone economies are worsening, thus necessitating further bail-outs.

This cycle of expectation-setting, disappointment, and relief is emotionally exhausting for market participants.  More importantly, it becomes exhausting for the European public and the leaders themselves.  Such exhaustion leads people to try to escape from the noxious situation.  If positive means of resolution are not found after 2-3 years, then drastic measures are viewed as more desirable - anything to "stop the pain", including more severe short-term pain as long as some ultimate relief can be seen on the horizon.

As long as there are multiple potential outcomes (uncertainty), investors will shun European equities and bonds and eventually the Euro.   At this point, a workable plan will involve political and budgetary check-and-balances, if not a direct political union, to balance the monetary union.   Once that uncertainty is resolved (a "probability collapse" in psychological jargon), a real relief rally will ensue.

The founders of the United States appeared to understand the human psychology of power (and the ease of corruption).  As a result they designed a governmental system of checks and balances between the executive, legislative, and judicial branches to prevent excess power in one branch.  Yet  democracy can be undermined by excessive short-term thinking with finances and budgets, and there is no legal check on the power of legislators to over-promise and overspend, and as we have seen, voters have little ability to understand (nor react appropriately to) fiscal profligacy among leaders.

Fortunately a group of UCLA behavioral economics researchers founded a behavioral policy journal to stimulate ideas and research in improving public policy through an understanding of behavioral incentives.  The journal's founders also provided the Obama campaign with strategic tips on boosting fund-raising.  The George Clooney celebrity dinner?  Yes, behavioral economics-inspired.  The lottery for a "regular-guy" seat to that dinner?  Also behavioral economics in action.  One enjoyable aspect (perhaps the only pleasant part?) of this year's U.S. presidential contest will be watching behavioral strategy employed.  We've expanded our text-analytic software to include political figures, so we'll keep track of the major races this year out of personal curiosity and will keep you posted on our findings.

Clearly there is a lot of fear in Europe.  Below is an image of the amount of Fear expressed in all news reports about Italy versus the United States through January 2012.  For several years Italy managed to avoid the contagion of the Euro-zone instability.  But now fear is squarely on Italy's doorstep.

Because of such fear in the Euro-zone, investors have fled in droves.  The Economist Magazine recently noted that European equities are trading at an average P/E ratio of 11, while U.S. equities have a P/E of 18.  As a result, European stocks are "cheap", and once the uncertainty is resolved, a massive rally may ensue.  Southern European bank stocks are a call option on a Euro-zone reconciliation, but there is a risk of nationalization of dysfunctional banks.   Financial firms that were indiscriminately sold alongside European banks, such as insurers and brokerages, are better investments. 

In the short-term, the next anticipated event is the Greek election of June 17th.  The outcome is uncertain, but a favorable short-term result (favorable for Greece to stay in the Euro) is likely.  That said, Germany still must decide whether or not to deliver additional bailout payments, and given Greece's lack of tangible progress in reforming their tax collection system and pensions, additional bailout funds are uncertain.

Ultimately, the European volatility will continue, to be followed by an acrimonious American election.  Yet as Warren Buffett has said, "The future is never clear, and you pay a very high price in the stock market for a cheery consensus. Uncertainty is the friend of the buyer of long-term values."

That said, any relief rally will likely last for months of duration (not years) and then stall.  The demographic headwinds facing Europe are significant long-run drags on the equity markets and economic growth.  The uncertainty developed world markets face is more fundamental than at any time since the Second World War.

Keep your chin up - this summer is a time to be thoughtful and opportunity-seeking during the short-term waves of anxiety as they sweep over markets.

We love to chat with our readers about their experience with psychology in the markets, so don't be shy - we look forward to hearing from you!  

We have speaking and training availability.  Please contact Derek Sweeney at the Sweeney Agency to book us: Derek@thesweeneyagency.com, +1-866-727-7555

Happy Investing!