Homo economicus vs. homo sapiens: why we invest not always rationally

In order to determine what is going on in the financial markets, it is necessary to understand what is going on in the minds of investors. Financial markets reflect the human nervous system much more accurately than the state of the economy, believes psychologist Mikhail Tegin.Why the "ideal rational" from textbooks does not work, how our lifestyle and wallet thickness are connected, why "we all come from childhood"? Oninvest is starting a series of materials on why rationality remains a theory, while emotions and cognitive distortions become the real cause of prices and bubbles. Series one.

For a long time, economic science was built around the model of homo economicus - economic man. It was formed in the XVIII-XIX centuries, and its father is considered to be the English scientist Adam Smith, the author of the term "the invisible hand of the market".

Things are supposed to be fairly predictable in the world of homo economicus - investors have complete information, meaning they know everything about the company, the market, and geopolitics.

They are like supercomputers, instantly processing billions of variables and always calculating the fair value of an asset without error.

The goal is to maximize utility (or profit) while minimizing risk. And, of course, the absence of emotions: investors from the world of homo economicus do not panic, are not greedy, and do not succumb to herd mentality. Their actions are always rational. The problem is that in reality, man is homo sapiens.

On October 19, 1987, the Dow Jones Industrial Average fell 22.6%, the sharpest one-day collapse in its history. There was no war, no bankruptcies, no macroeconomic disasters. But there was fear - and the speed at which it spread.

Investors were selling not because they had recalculated future cash flows, but because they saw others selling. Decisions were made not through analysis, but through a feeling: if I don't get out now, it will be worse. Fear, which quickly turned into panic. Panic became not a consequence of the information received, but a substitute for it.

There are two big forces that shoot down our rationality. It is as useful to learn more about them as it is to learn more about the issuer of the security.

Strong fear, which has enabled humans to survive, works differently in the market. It refers to affects - quick, powerful psychophysiological reactions. In 2008, when major financial institutions collapsed, there was a credit freeze in the markets because everyone was afraid to lend money. All this led to the global financial crisis of 2008. FOMO - Fear of Missing Out, the Fear of Missing Out Effect - is on the list of the most current research in the field of investor behavior.

Emotions less intense: joy, pride, and anxiety, the "daughter" of fear, can also influence your decisions. For example, pride in a successful investment may prevent an investor from selling a growing asset, hoping for even more growth to reinforce his or her identity as a "genius investor". On the other hand, pride can prevent an investor from locking in losses, as it can be perceived as an admission of poor judgment and "losing" to the market - we saw this with the early history of bitcoin's ups and downs. Anxiety, on the other hand, can cause what is known as decision paralysis.

In moments of market growth, we can get greedy - we buy at the peaks, ignoring the risks. The classic example here is the dot-com bubble. In the late 1990s, investors, euphoric and greedy, and delighted by the new technology, bought shares in Internet companies en masse, completely ignoring the companies' lack of profits. Reminds you of AI, doesn't it? As a result, stock prices reached unprecedented heights. But in March 2000, greed was replaced by fear, and the bubble burst and the NASDAQ index plunged more than 78%. Investors lost an estimated $5 trillion.

At the same time, the fear of loss, as Kahneman and Tversky's study showed, is felt about 2-2.5 times more strongly than the joy of an equivalent gain.

Social pressure and emotional contagion, that is, situations where we see others getting rich, also contribute to the formation of price bubbles through irrational and speculative behavior.

The second driving force is cognitive distortion. Our brain is a brilliant but lazy organ. It likes mental "shortcuts", i.e. it does not analyze everything anew, but acts according to a pattern of rules it has developed in another -similar situation. Here are just a few examples.

- Confirmation bias. We tend to seek out and memorize information that confirms our existing beliefs. If an investor believes that N stock will grow, he will tend to look for and read only those articles that reinforce his belief and ignore critical materials.

- The anchoring effect. A person tends to rely too much on the first information received, even if further information is not so relevant. This is the work of the law of marginal utility at the level of cognitions, thinking.

- Overconfidence - overconfidence. Investors may overestimate their knowledge and abilities, believing that "I certainly know more than the crowd", resulting in overly risky transactions.

Rational man is a beautiful but unsustainable model. The rational man is a complex, sometimes chaotic reality with a mixture of logic, fear, greed and systematic errors of thinking.

It is emotions and cognitive distortions that are the "invisible hand of the market". Invisible forces that create bubbles, provoke panic and lead to suboptimal investment decisions.

Therefore, the classical incompleteness of information does not necessarily have to be covered by more and more information about the issuer, paper or market. A reasonable person, a reasonable investor can supplement the incompleteness of information about the market with deeper knowledge about himself - about how the human brain works and the psyche is organized. After all, irrationality will hardly go anywhere by itself, and it is impossible to get rid of it. But you can learn to manage it and then you will be able to act more consciously.

This article was AI-translated and verified by a human editor