It isn’t always good to know what other investors are thinking.
In recent years, a branch of scientists known as neuroeconomists have discovered a connection between a person’s ability to recognize what others are thinking and how well that same person’s investment portfolio will likely perform in the next market crash. And the connection is not a positive one.
The ability to make inferences about someone else’s mind is normally seen as a crucial mental talent. It facilitates social interactions and empathy. But in a 2013 paperpublished in the scientific journal Neuron by Benedetto De Martino and colleagues, then at the California Institute of Technology, the authors uncovered a surprising downside to this most human skill.
The scientists observed that in tests that measure one’s ability to infer another person’s state of mind—a so-called theory-of-mind test—subjects who performed well also showed patterns of brain activity associated with increased betting during bubble markets. The authors suggest that over time this could lead to greater financial losses.
What explains this correlation? One possibility is that investors who are more attuned to the behavior of others are more prone to herd behavior. When they notice someone bidding up a given asset, or panicking and selling after the bubble has popped, they are more likely to join in that activity, even when the price of the asset deviates greatly from its intrinsic value. For these sensitive people, irrational exuberance, and panics, are extremely contagious.
Such theories raise an especially important question in the 21st century. We live, after all, in the age of the social network, with hundreds of millions of people interacting on sites such as Facebook and Twitter. While these sites make it far easier for people to learn about one another, they might also make us more sensitive to market swings.
An informal survey I’ve conducted with investors in my own social network suggests that most financial firms have yet to develop a coherent strategy to deal with this type of vulnerability. When I asked people if they’d been contacted by their financial institution or adviser after the last sharp market correction in August, almost everyone said their financial institution was “not effective” in helping reduce their anxiety about market events.
The question is what an effective response would look like. One potential solution is personalized text messages to deliver customized content in the midst of a sudden downturn. Studies show that personalized information is far better at grabbing our scarce attention, whether in the classroom or our inbox.
After a market correction, these personalized messages could be pushed directly to investors’ smartphones, attempting to calm people by describing relevant academic research. For example, the messages could emphasize that most investors aren’t good at market timing.
Firms might also focus their interventions on clients who score higher on tests showing their susceptibility to other people’s behavior, as they might be most susceptible to bubbles and busts.
Another possible solution involves a commitment contract, or an agreement designed to help a person achieve goals. Studies have shown that smokers are more likely to quit when they commit to giving six months of their savings to charity if they fail a test for nicotine. A similar strategy could be used to prevent impulsive selloffs. Perhaps investors should sign an agreement with their financial advisers requiring that, after a market downturn, they have to run five miles before deciding to sell. (A wearable gadget could be the referee.)
Texts and commitment contracts won’t prevent the next panic. But financial firms should develop digital tools to help clients deal with their impulsive emotions. When investors are flooded with bad news it’s important to help them put their feelings in a broader context. Instead of following the herd, they should follow history: Buy and hold is still a great long-term strategy.