Business Briefings
Now, let's take a look at the most important research findings from various fields of study.
Economists argue that markets usually reflect rational behavior, that is, the dominant players in a market — such as the hedge-fund managers who make billions of dollars' worth of trades — almost always make well-informed and objective decisions.
Psychologists, on the other hand, say that markets are not immune from human irrationality, whether that irrationality is due to optimism, fear, greed, or other forces.
Now, a new analysis published in the Proceedings of the National Academy of Sciences supports the psychologists' view, indicating that markets are susceptible to psychological phenomena.
In their analysis, the researchers studied an effect called partition dependence, in which breaking down — or partitioning — the possible outcomes of an event in great detail makes people think that those outcomes are more likely to happen.
The reason, psychologists say, is that providing specific scenarios makes them more explicit in people's minds.
For example, if you are asked to predict the next presidential election, you may say that a Democrat has a 50/50 chance of winning and a Republican has a 50/50 chance of winning.
But if you are asked about the odds that a particular candidate from each party might win — for example, Hillary Clinton versus Chris Christie — you are likely to envision one of them in the White House, causing you to overestimate his or her odds.
The researchers found evidence of this bias in a variety of prediction markets, in which people bet on future events. The researchers created two prediction markets via laboratory experiments and studied two others in the real world.
One of the studies of natural markets involved a series of 153 prediction markets run by Deutsche Bank and Goldman Sachs, and another involved long-shot horses in horse races.
For example, people tend to bet more money on a long-shot horse, because of its higher potential payoff, and they also tend to overestimate the chance that such a horse will win.
Statistically, however, a horse's chance of winning a particular race is the same regardless of how many other horses it's racing against — a horse that habitually wins just five percent of the time will continue to do so whether it is racing against fields of 5 or of 11.
But when the researchers looked at horse-race data from 1992 through 2001 — a total of 6.3 million starts — they found that bettors were subject to the partition bias, believing that long-shot horses had higher odds of winning when they were racing against fewer horses.
Resources
Proceedings of the National Academy of Sciences, May 17, 2013, "How Psychological Framing Affects Economic Market Prices in the Lab and Field," by Ulrich Sonnemann, et al. © 2013 National Academy of Sciences. All rights reserved.
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