Emotional Investors and the Fed

"Any emotion, if it is sincere, is involuntary." --Mark Twain

Last week, the Federal Reserve surprised us with good news! Ms. Yellen announced they decided not to raise interest rates. What did the stock market do? Decline on the good news.

Afterwards, we read about and listened to the reasons why, and they had something to do with "good news for bonds and so money went there" and "stocks decline on growth worries," but let's face it: nobody knows. Nobody knew in advance. We rationalized after the fact.

Last week, Dr. Tom Howard from Athena Invest and Mike Pacitto from Litman Gregory spoke to our clients in part about behavioral investing. Dr. Howard is a thought leader in the field.

Emotion permeates everything we do as investors. Daniel Kahnemann, Nobel Prize winner points out how cognitive biases affect our judgment and decision-making in his book, Thinking Fast and Slow.

I'll argue that what really happened last week was that investors are suffering from what Kahnemann would call an availability cascade.

"An availability cascade is a self-reinforcing process of collective belief formation." In other words, we hear news, we repeat news, and the more we hear it repeated, the more we repeat.

Example #1: the U.S. presidential campaign. The more we hear about a candidate, the more plausible he becomes as a candidate, and this self-reinforcing process makes it all the more likely to happen.

Example #2: last week's Federal Reserve decision. We hear that the Fed's decision affects the stock market and we believe it. We repeat it. We witness a surprise that counters our beliefs, like last week's non-decision. Someone gives us an idea that confirms our bias (that the Fed affects the stock markets). We believe it, we repeat it, and the more we hear it repeated, the more we believe it.

This emotional driver called "availability cascade" is married to another emotional decision maker, "confirmation bias," which we'll cover next week.

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