The pervasive influence of psychology in the markets

“The purpose of studying economics is not to acquire a set of ready-made answers to economic questions, but to learn how to avoid being deceived by economists.”

– Joan Robinson

At the start of my career in the capital markets, I used to be somewhat defensive about not having studied economics. Then, in seemingly short order, came the Asian Financial Crisis, the collapse of Long Term Capital Management, the dotcom bust, the US property bust, and the Global Financial Crisis. After which point it became obvious that PJ O’Rourke was precisely right: economics really is “an entire scientific discipline of not knowing what you’re talking about”. Or, as someone mildly corrected him: “I take issue with your use of the word ‘scientific’.”

But it is all too easy to accuse economists of being quasi-scientific charlatans (which most of them are – and it makes them all the more dangerous for not being aware of the fact). Rather than turn this commentary into a counsel of despair, what practical advice is there for investors looking for guidance and a way forward through a thicket of confusion?

It turns out that my English degree was not the worst preparation for a career in high finance. The classics of English literature are classics for a reason. They deal with timeless issues of human emotion, ambition and interaction. And isn’t that a perfect description of the financial markets?

But if I were asked for subjects in which I suspect our schools and universities are not yet giving students a sufficient grounding, two would stand head-and-shoulders above the rest: negotiation and psychology.

The shambles of our Brexit negotiations are an object lesson in how unfit our politicians and civil servants are for the task to which they have applied themselves. Yanis Varoufakis, the former Greek finance minister and author of Adults in the Room, has some experience of negotiating (albeit not necessarily successfully) with Brussels. Earlier this year he made the following criticisms of the UK government’s negotiating strategy, such as it has had one:

First, the British Government erred in imagining that the EU’s considerable economic losses from a no deal translated into a strategic incentive to negotiate in good faith. Secondly, Mrs May committed an elementary mistake in accepting Mr Barnier’s two-phase negotiation process which committed Britain to giving the EU everything it demanded before discussing Britain’s demands.

Thirdly, an extension of Article 50 for the purposes of extracting a better deal from the EU is delusional – since a reset day N will not give Brussels reason to change its stance before the new day N arrives. Fourthly, Mrs May’s withdrawal deal deserves to be ditched courtesy of another fixed deadline that is embedded in it which, effectively, extends the current phoney negotiation, and standstill, until the final day of the fixed transition period.

What should the UK Government be doing instead? When faced with a fixed deadline and a disadvantageous default outcome, there is only one thing to do: select your dominant strategy; the strategy that you consider your best response to everything the other side may throw at you; a strategy whose appeal does not rely on the success of bluffs, threats or enticement.

Is there anything to be done? The UK government has made its Brexit bed and must lie in it. As for the rest of us, we could do worse than secure a copy of Chris Voss’ book Never split the difference, which is a guide to negotiation written by a former FBI hostage negotiator. Now that is an example of skin in the game.

Negotiation plays a role in almost every aspect of our lives. The only environment in which negotiation is not present that I can think of is one in which someone lives entirely in isolation, which brings a different order of challenges (see our piece Be a contrarian – enter the cave! in Master Investor Issue 47 for more on this theme). We negotiate daily with members of our family, with friends, with colleagues, with business rivals, and counterparties – how on earth did such a fundamental aspect of human life manage to evade our educational system?

As Chris Voss puts it,

Negotiation is a psychological investigation. You can gain a measure of confidence going into such an investigation with a simple preparatory exercise we advise all our clients to do. Basically, it’s a list of the primary tools you anticipate using, such as labels and calibrated questions, customised to the particular negotiation.

When the pressure is on, you don’t rise to the occasion – you fall to your highest level of preparation.

Which brings us to the next big deficiency at the heart of our educational system – its inability to teach the most fundamental aspects of human psychology.

While I haven’t studied psychology in any formal sense, I have had the benefit of working in the financial markets for nearly 30 years, which is pretty good preparation. All of human life is there, warts and all. But if I were only allowed one book to recommend on the topic, it would be Robert Cialdini’s Influence: the psychology of persuasion. I have yet to visit any marketing company or ad agency and not see copies of this book adorning the shelves.


As someone who initially wanted to work in advertising (happily, fate intervened and sent my career down a different path), I have long been drawn to stories about the creative folk who inhabit the world of Adland. Rosser Reeves was one of the most celebrated American advertising executives from the 1950s onwards – he helped define the era of Mad Men. There’s a story about him, now many times retold, that goes as follows. Reeves and a colleague were having lunch one day in Central Park. On their way back to Madison Avenue, they came across a beggar. The man was holding a cup for donations and a handwritten cardboard sign, that read:

I AM BLIND.

Sadly, the man’s cup was almost empty. His plight, for some reason, was not moving people to donate. Reeves immediately told his colleague that he could see what the problem was; he bet his colleague that he could dramatically increase the money in the beggar’s cup, simply by adding four words to his sign. His colleague, intrigued, took him up on the bet. Reeves then introduced himself to the man, explained that he was in advertising, and offered to change his sign slightly to increase people’s willingness to give. The man agreed. Reeves took out a pen, added his four words, and with his colleague stepped back to watch. Almost immediately, passers-by started to drop coins into the blind man’s cup. Others came by, began talking to the man, and took dollar bills from out of their wallets. Pretty soon, the man’s cup was overflowing with cash. What four words did Rosser Reeves add to the sign?

IT IS SPRINGTIME AND

The new sign, that captured the sympathy and triggered the generosity of passers-by, read:

IT IS SPRINGTIME AND I AM BLIND.

By nudging people to put themselves in the position of the beggar, Reeves was exploiting something psychologists call “the contrast principle”. He was arguably “guilting” people into giving. But most observers would conclude that, assuming this story isn’t apocryphal, the end justified the means.

The mistake that many private and professional investors make is to concentrate on “the numbers”. But financial data, no matter how reliable it is, can only be the start of the investment journey. My friend Guy Fraser-Sampson puts it as follows,

Finance is at best a social science studying human behaviour, like psychology or sociology, and can never be a physical science such as physics. It is for this reason that neither observation nor mathematical techniques can ever offer any valid universal guide to future outcomes.

So, when John Maynard Keynes wrote, during the depths of the Great Depression, that “we have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand”, his analogy was poignant, but not quite accurate. Keynes was looking for a lever to move the economy, but the lever does not exist. The economy as machine does not exist. The metaphor Keynes used has no grounding in objective reality.

The final word should perhaps go to the one group of economists who saw what Keynes did not. The so-called Austrian, or classical, economists, recognised something that the scientific economists could not. The economy is not just some abstract assembly of cogs and wheels and inputs and outputs that can be neatly sliced and diced and subject to mathematical theory. The economy is us. Investors ignore the human dimension to financial markets at their peril.