08/03/2012 06:36 pm ET | Updated Oct 05, 2012

What Is the Stock Market Thinking?

If the stock market was a person -- gosh, if corporations can have the same rights as people, why can't the stock market have thoughts and feelings? -- he could be diagnosed with a wide range of psychiatric disorders (I don't mean to be sexist, but the majority of people in the stock market are male and, if it was a female, I can't imagine it acting so strangely): multiple personality disorder, borderline personality disorder, bipolar disorder, generalized anxiety disorder and, of course, depression, just to name a few. Or perhaps the worst diagnosis the stock market could be given is that of flawed humanity. The real question I have been asking myself of late is: What is the stock market thinking?

I pose this question because I am at a loss to explain the impulsive, seemingly irrational, and oftentimes self-defeating behavior exhibited by the stock market. Of course, the market has always shown volatility, but recent analyses indicate that it has been particularly unstable in the last few years. The last few weeks have exemplified this instability, with swings of hundreds of points up and down from day to day repeatedly.

What is particularly scary is that the stock market not only reacts hastily in response to some objective economic news, for example, the unemployment rate rises or consumer confidence declines, but also on rumors or possibilities that may or may not be realized. For example, the market has been known to rise or fall based on the belief that the Fed may raise or lower interest rates. So, the market experiences a double dose of volatility, first based on the fear or hope of some financial event occurring and then when that event either does or does not become a reality.

I understand that, following the Great Recession, there has been an epidemic of smaller financial crises (e.g., European debt, mortgage) that has created considerable uncertainty about the economic futures of the U.S. and the world at large. Everyone involved in the financial markets, even seasoned professional traders, is understandably skittish about the future.

Additionally, technological advances have contributed to the market insecurity. There is more information more readily available than ever before. Also, the constant presence of smartphones and computers enables traders to react quickly to financial news, often based on fear or greed rather than analysis or reason.

There have also been suggestions that there is a greater focus on high-frequency trading and short-term profit-taking these days, abetted by technology, but they don't appear to fully account for the dramatic market fluctuations.

Others have argued that globalization has created a hypersensitivity among investors to the so-called Butterfly Effect (a localized change in one part of the world produces a significant change somewhere else), for example, the Japanese tsunami in 2011 and its impact on international financial markets.

Yet, the volatility does appear to go against the stated aims of financial firms and investors alike. The vast majority of the daily trades are done by professional traders who are employed by financial firms that are, in turn, presumably interested in the long-term financial security of their clients and represent individuals and institutions generally concerned with long-term investment (e.g., retirement, college education, endowment) rather than short-term gains. As such, you would assume that these professionals have a long-term investment strategy that drives their trading (as compared to retail day traders who are out to make a quick buck). Moreover, you would think that a genuine faith in and commitment to that strategy would cause them to be resistant to the daily vicissitudes of the global economy.

Certainly, you would expect that anyone with a confidence in their approach to investment would stay the course rather than be influenced by daily turns of financial events, whether threatening or encouraging. Particularly given the history of the stock market, in which recoveries have always occurred following a crash, daily events rarely have meaning in the big picture of the stock market (case in point, my wife's and my investment portfolio has surpassed its pre-Great Recession state after losing almost half its value).

Of course, there are short-term considerations that go into long-term investing. Economic conditions can create opportunities for buying and selling at certain times that have long-term benefits. Additionally, despite protestations to the contrary, there is considerable evidence that individual traders and the financial management firms that employ them sometimes act out of self-interest, more specifically, trading for immediate profit, when market conditions allow it.

But these opportunities can't account for the wild swings that occur when some seemingly consequential piece of financial news "rocks" the stock market. If such news was so catastrophic, causing a drop of, say, 300 points on the Dow, how to explain a rebound of several hundred points the next day (or a gradual return over the course of a week). If traders had simply stayed with their original position, there would have been relative stability in the market and far less stress on all those involved, from the traders to the regular folks worried about their IRAs.

I'm no expert in finance or economics, but I do know a thing or two about human behavior. And the monolithic stock market is really just a conglomeration of people with individual values, attitudes, perceptions, motivations, goals, and emotions. As the growing field of behavioral economics has demonstrated, the conventional wisdom of people as "rational actors" is simply not true.

Daniel Kahneman, a psychologist, and Richard Thaler, a behavioral economist, have separately shown how truly irrational people's thinking can be, guided by decidedly nonrational forces including unconscious perceptual distortions and cognitive biases and faulty decision making, resulting in decisions that produce results far from the desired outcomes. Moreover, the credit that financial professionals give to themselves (and often get from their clients) for great market returns has been shown to be an illusion. John Coates, a former derivatives trader-turned-neuroscientist, goes even deeper by demonstrating that brain chemistry causes traders to shift, as he puts it, from dog to wolf and back again, becoming either risk prone or risk averse, depending on market conditions.

So what are the most common psychological influences on the stock market? Let's take a look.

Herd behavior involves basing decisions on what others are doing to feel safe or avoid conflict. Individual investors see others buying or selling and, in order to not be left out of the profit-making or left taking the losses, respectively, they follow suit. Of course, herd behavior has to begin with one person's actions and there is no way for others to know whether that "catalyst's" behavior was rational or appropriate. Related is the bandwagon effect in which people's behavior is shaped by observing others -- "If others are doing it, it must be the right thing to do."

Recency bias involves investors paying more attention to the latest data rather than putting the immediate market conditions into a reasonable long-term context. This bias causes traders to see trends that are, in fact, random shifts that have no predictive value for the market.

Loss aversion involves our inclination to avoid losses rather than produce profits. Investors are resistant to selling stocks if they might incur a small loss. The result? They hang onto a stock until they have to sell at an even greater loss. Escalation of commitment is a related bias that involves the tendency to remain committed to a losing proposition the longer it is held. Traders, for example, are unwilling to let go of their sunk costs with a stock they have held for a long time in the hopes that it will turn around.

Confirmation bias involves the propensity to seek out or interpret information that will validate our beliefs. For example, if a trader really likes tech stocks, he or she is more likely to look for market information that will justify buying or retaining them and dismiss contradictory information.

Illusion of control is the tendency for people to think that they have control over situations where they objectively do not. Investors will often attribute gains on their trades to their wise decisions rather than, more likely, random variation in the market. Illusions of control can lead to the overconfidence effect in which people are far more certain of their judgments than objective evidence would support.

Hyperbolic discounting refers to the penchant for us to favor smaller, short-term rewards over a greater, long-term rewards. Investors, for example, may see the opportunity to make an immediate profit by trading a stock when hanging onto it will be much more profitable in the long run.

The list of cognitive biases that contribute to the craziness of the stock market goes on and on, but I will conclude with the bias blind spot that involves the unwillingness to recognize or admit your own cognitive biases. The bias blind spot is perhaps the most important cognitive bias because it prevents investors from being aware of and, potentially, resisting the cognitive biases that will inevitably color their trading decisions.

Where does that leave us, the relatively unsophisticated investor or seasoned professional? Well, if the evidence is to be believed, we definitely shouldn't leave our money with anyone who will be actively trading it in the stock market or be trading regularly ourselves. The best advice I can gather is that we should rely on a tried-and-true investment strategy, namely, put our money in a diversified portfolio and leave it alone, regardless of the cognitive tricks our minds play on us or the emotional roller coaster we may experience if we follow the daily gyrations of the stock market.

A commitment to this hands-off investment strategy can act as the guardian to our money when the deranged maniacs of cognitive bias and the ravenous beasts of emotions and impulsivity are snarling at the gates of our castle. By understanding the forces that can lead to bad financial decision making, we have the ability to mitigate their influence and, as a result, resist the Sirens call of our ill-advising physiology, thinking, and emotions during times of financial upheaval.