Behavioral Finance, Confidence, and the Bailout...

Behavioral finance is the study of social, cognitive, and emotional factors in order to better understand/explain stock market anomalies. Some theories that exist in behavior finance include; the media effect, herding instinct, and market psychology. For the most part, these theories are somewhat self-explanatory, but if you are interested in learning a little bit more about them, it is readily available here.

What we are currently seeing in the US economy is the direct result of some of these theories in behavior finance. To better explain this, let's examine the closing values of the Dow Jones Industrial Average Index (DJIA) over the last week, as well as what headlines dominated the news.

Monday, September 22, 2008 - 11,015.69
Lawmakers Battle Over Rescue Plan -WSJ
New world on Wall Street -CNN

Tuesday, September 23, 2008 - 10,854.17 (-161.52)
Doubts on Rescue Plan Spur Fall In Dollar, Leap for Oil -WSJ
Bailouts will lead to rough economic ride -CNN

Wednesday, September 24, 2008 - 10,825.17 (-29)
Rescue Plan Stirs Calls for Deeper Regulation -WSJ

Thursday, September 25, 2008 - 11,022.06 (+196.89)
Bailout Pact Gains Momentum Amid Push for Tough Controls -WSJ
Dollar higher on bailout hope -CNN

Friday, September 26, 2008 - 11,143.13 (+121.07)
Bailout Negotiations in Disarray -WSJ
Dollar mixed on bailout strife -CNN

Monday, September 29, 2008 - 10,365.45 (-777.68)
'No' vote on Bailout Hammers Stocks -WSJ
No Love for Bailout -CNN
U.S. Stocks Battered As House Rejects Bailout -FOX
Bailout failure throws banks into disarray -MSNBC

Tuesday, September 30, 2008 - 10,850.66 (+485.21)
Hope for New Plan Rallies Stocks -WSJ
Senate: Stop 'blame game' over bailout failure -CNN
White House Says Mortgage Rescue Plan Remains n Track -FOX
McCain, Obama urge financial rescue action -MSNBC

Note: I tried to draw headlines from multiple media outlets, but as you can see, there are fewer headlines from last week as I was somewhat lazy in searching for them...

To summarize...

Last week's news of the bailout brought some small fluctuations in the market, and by small I mean not the 300 point swings we have been seeing more and more often. Still, having no hard evidence on which way the bailout vote would go, investors entered somewhat of a holding pattern and the DJIA remained still.

By Thursday, news of an agreement in principal on a bailout proposal was announced, which resulted in a small boost to investor confidence. This boost was continued on Friday as it appeared that the bailout would pass during the following week.

On Monday, news hit that the bailout bill has failed to pass the House of Representatives. With no other plan of action in sight, this caused widespread panic in the US financial market and the DJIA fell over 770 points.

Today, as reports come in that new life has been given to the bailout, the DJIA rebounded 485 points. It is now likely that we will witness another holding period where we will see smaller fluctuations in the market as investors react to small bits of news, in anticipation for the bigger news on whether or not the bailout will pass on the second go around.

The point...

All of this is a prime example of behavioral finance, at the root of which is investor confidence. If anything, a bailout will inspire the confidence needed for the market's rebound. As news trickles down, people will stop panicking and the wheels of the US financial markets will start moving again. Deposits will stabilize, liquidity will increase and banks will continue to make loans. In turn, this will encourage economic growth and improve the health of the US economy. All because of confidence.

At this point, a $700 billion dollar bailout is not as much a matter of provisions, oversight, or even amount. Right now, a bailout is about creating confidence in the US economy and removing the underlying cause for fear in the financial markets (sub-prime mortgages).

Some will most surely point out that confidence is a pretty weak argument to stand on. Granted that may be the case, it is a lack of confidence that caused the US market to lose $1.2 trillion dollars yesterday.

As of right now, the only confidence that exists in our economy is the overconfidence of many Americans who believe that our financial markets will fix themselves without the aid of Congress. It is this overconfidence that prevents them from seeing the negative impact that every American will feel as a result of inaction and the continued reliance on the inefficient tools that the Treasury, Fed, and FDIC currently have at their disposal to combat this crisis.

In closing...

All in all, confidence is a silly thing. Yet somehow, this emotional state of mind has the power to alter so many things in our lives, be it an athletic competition, an interview, a relationship, or even our economy. It is my hope that during the next few days a bailout will be passed and that some confidence will be restored to the US economy and the American people. I hope that you will join me in that hope.

Thank you for listening. May God bless you.

-dunkie, '08 presidential nominee