Psychological and Social Forces Behind Aggregate Financial Market Behavior

Abstract

Abstract The cycle of boom and crash is a “natural” element in financial market history, and numerous research works have provided evidence that market prices spend far more time deviating from postulated theoretical equilibrium than actually tending towards it. In particular, nonmean-reverting dynamism in financial markets may be produced by mass psychological dynamics in the patterns of human aggregate behavior, which result from nonrational herding impulses sensed by market participants in complex and uncertain situations. Based on a literature review and the analysis of several case studies, this paper elucidates postulated mechanisms behind, and characteristics of, herding in financial markets. The main goal is to raise awareness of the often little-understood point that collective behavior does not simply sum up preexisting individual motives and preferences. Thus, the paper focuses on the mechanism of how individually unintended aggregate outcomes such as financial market booms and panics are shaped by collective dynamics and social interactions between traders and their social environment. Keywords: Speculative bubbles and crashesBehavioral financeHerdingContagionOther-directedness Notes 1. Before the outbreak of the crisis of 2008–2009, the U.S. household debt to Gross Domestic Product ratio had risen from around 50% in the mid 1980s to its peak of 98% in 2008. In particular, U.S. household mortgage debt had nearly decupled during the past three decades, while the number of households in the United States had only risen by a fourth. By summer 2007, the average U.S. personal savings rate had fallen into near-zero territory starting from +9% in the mid 1980s (Data Source: Federal Reserve Board www.federalreserve.gov).