At a glance, psychology and finance appear to have almost nothing in common. Money, by its nature, is a social construction, quantitative, and seemingly resides “out there” apart from feelings, memories and emotions. The human mind, on the other hand, is subjective, biological, and “inside” of us.
But, as it turns out, what people do with money says a lot of how they are thinking and feeling. Traditional economics, for instance, makes claims about how people really are. Adam Smith, perhaps the most influential economist of all time, established classical economics, the field for which the “rational man,” or, to use contemporary parlance, rational person model was established. In short, for many, centuries, economists claimed that men and women would in most instances act rationally, act selfishly, and act what is in their best interest. Under this model, people are logical, rational, and reasonable.
But is this really how people behave?
Another more recent field, behavioral economics, has emerged in recent years, which challenges the traditional rational person model. Behavioral economics, by contrast to classical economics, takes human emotion and psychology into account when it attempts to explain individual financial choices, government macroeconomic policy, and how humans deal with money in general. Behavioral economics uses current psychological research as a basis for its claims about how individuals really are in an attempt to explain economic behavior.
One obvious example of how psychology and finance interact is the stock market. The stock market, in a way, is an up-to-date measure of “mass psychology”—the market acts and reacts to news instantaneously. When things are stable, news is good, and all appears well, the market reacts positively. When things appear unpredictable, when a major political decesion is made that can produce uncertainty, on the other hand, the market may act negatively. This is, of course, the most that can be said about market reactions because many people for many years have tried to predict how news of a certain flavor can accurately predict market outcomes, and all who have tried this have failed.
It is interesting to see how an individual’s knee-jerk response to some unfortunate news can set off a chain of events to lower the price of your best performing stock . . . or improve a poor stock among good news.
That said perhaps it is time for the “rational actor” model to be updated. It is well known among clinicians, psychologists, and others working in related fields that humans usually do not act rationally. In many instances, humans are petty, emotional, shortsighted, and—on the other hand—humans may act altruistically at their own expense, which, on the latter point, flies in the face of traditionally economic thinking. Although no one can accurately predict the future of a stock or how the day’s news will elicit specific financial outcomes, we do know a little more about how the human mind works than our historical antecedents who did their best to devise an accurate economic model.
Still, it remains interesting to see the interaction between mind and money on the economic playing field . . . in many cases, one may say something important about the other.