Illusions of confidence drive Wall Street and the whole stock market

We just had an unique opportunity to gaze at the effects of a psychological phenomenon in live, en masse.

First, Context:

Recently, in the late weeks of January and early February 2021, the social network of Reddit was the center of much attention when a large group of users from the subreddit r/wallstreetbets bought a large amount of stocks from GameStop, a video game company that has been struggling in the last years. 

The sudden demand coupled with other factors made the price of the stock skyrocket, with several users, mostly normal middle class folk, making thousands to millions overnight. 

The initial successful prediction made certain users rally others into avoid selling to cash in these millions and keep holding the stock for it would increase in value even more.

The results were this, so far, to the right the more recent dates:

If it looks like something bad... it is 🚀

It peaked nearly at 380 USD twice and at the time of writing this it sits at 50 USD.

Consider the frenzy started to become mainstream when it was increasing towards 100-150 USD per stock, so many buyers potentially lost a LOT of money just a couple days in.

The first day the price crashed the subreddit was flooded with stories of college students that spent loans to buy stocks, single mothers who betted their life savings and worse, now in despair as their money disappeared before their eyes.

The initial risk-taking was commendable but those who followed the predictions of others took a hard lesson from this.

An Illusion that makes money

Photo by Karolina Grabowska from Pexels

The human mind has a tendency to give causal explanations to everything and a known aversion to explain things with chance, like luck. Causal explanations make the world appear a lot more simpler and tidy than it is, which in turn keeps at bay feelings of anxiety.

If a biker has a traffic accident, our minds immediately jump to conclusions: he probably was careless, was doing something dumb or was the victim of a drunk driver. If a CEO succeeds in a project dozens of others have previously failed she is perceived as skilled, unique and powerful, a true leader.

But we rarely tag these events as lucky or unfortunate, which in other words means a product of absolute randomness. Suggesting “Luck” to the success of a person will come across in the best of cases as rude, and in the worst as envious and spiteful.

It is socially acceptable to give them a paranormal or even a divine explanation before thinking of them as results of luck.

After all, whose mind can easily reconcile with the chaotic nature of life?

Maneki-Neko or "Beckoning Cat" is a Japanese symbol of good luck, increasingly popular in the western world.
Photo by Miguel Á. Padriñán from Pexels

Why? Are we to assume the way we feel about a situation is always wrong?

Of course not. Our initial readings will be well aligned with the context, and for most occasions that’s enough, but we are really bad at predicting the future and especially inaccurate when interacting with complex systems, such as the stock market. 

The reason for this is a cognitive bias noticed and documented first by the Dr. Daniel Kahneman: The Illusion of Validity, we feel our confidence in making predictions is accurate and reliable when examining data, especially when it shows a clear pattern, or in other words, when it is coherent. 

And our brain does love coherence and order.

What can be learned from observing grunts lifting logs

Kahneman observed this when asked to evaluate military candidates for officers during an exercise. 

 

 

The soldiers were stripped of any identification document with rank or name, placed in random groups without a defined leader and tasked with moving the log from the starting point, above a 6 ft wall and without touching the ground OR the wall. If any of those conditions failed, the exercise had to start all over again.

The brutal activity made each man show their true colors. Some would try and fail to take leadership and become less cooperative, others would become meek in the face of the odds and all would be very stressed. 

The doctor and other colleagues were quick to identify and predict the odds for each one in the position of officer. “This one would be a failure, this other... not even grant him a chance! But that last one is a potential hero.”

Months later they were shown the trajectories of the soldiers they examined: Their guesses were but slightly better than BLIND guesses. There was close to zero correlation on their predictions and the actual outcomes. This wasn’t a trick with statistics or an error, as they themselves reviewed the results with care.

And it repeated over several trials, with different professionals, in many areas of work, to the point famous studies have been made on the topic advising the common folk to NOT trade much. 

They were shocked to discover this and even more perplexed to notice in a posterior examination of more aspirants that their own confidence in their skill wasn’t shaken at all. 

They felt  the same way about this next group of aspirants struggling in the exercise than they did about the last, despite evidence and awareness of the bias. 

This was a key landmark where logic and perception did not agree and only could be overcome with constant self-awareness.

The confidence in our predictions is not a judgment (logic) but a feeling (emotion). 

More than one group of psychologists has been spurned by a powerful CEO who was explained that the financial advisors from Wall Street he spent thousands on had slightly better accuracy than a caravan of dart throwing monkeys. 

As we’ll see in the future, this bias is the core reason billions of stocks are bought and sold in the market daily, for every soul is sure of their predictions, confident that their skill, and not lady luck, is the precursor of their success… but that often ends in monumental failure.