The final programme in the documentary series The Love of Money finishes by ascribing the causes of many financial crises, including the most recent, to a “reckless love of money”. Over the series, we have seen how reliance by banks on imprudent investments in property loans with high default risk led to the near total collapse of the world’s financial systems.

Was this the consequence of the actions of a powerful few, driven by extraordinary levels of greed and recklessness, or can the roots of the crisis be found in much more commonplace aspects of human psychology? I am going to argue that there is a great deal in common between the psychology of every day decisions about money and the psychological processes involved in the creation of this global financial crisis.

Consider two examples:

Jenny has recently lost her job, she knows that money is tight and she needs to reduce her costs dramatically, but every time she tries to think about sorting things out she feels bad and ends up by going shopping to cheer herself up.

Jared took on a 100% loan to buy a house with repayment levels he could only just afford. As he thought about this decision from time to time, he felt anxious about the possibility that he would not be able to meet the payments. He was able to avoid this anxiety by focusing on the way in which house prices seemed to keep on rising and by telling himself it was really a ‘one way bet’.

In each case there is a common factor: employing a strategy to avoid bad feelings and maintain good feelings, rather than facing the real problem or risk. We all behave like this from time to time. We all have strategies to regulate our emotions and often do so with the goal of avoiding bad feelings. However, when we feel particularly anxious or are powerfully motivated by an important goal, this tendency can cause us to ignore the important information that negative feelings can carry. Often this can involve fostering illusions about ourselves and the world around us which help us feel better.

Stock market results in a newspaper.
[image © copyright Jupiterimages]

We might imagine that professional financial decision-makers would be better at avoiding such traps. After all they work in a climate which places a great premium on rational decisions. However, in a large-scale study of 118 traders in four City of London investment banks, myself and colleagues found traders to be just as prone to these kinds of illusions as the rest of us. In particular we studied traders’ propensity to suffer from the illusion of control: the tendency to believe we are more in control of events than we really are (especially under stress). We found a significant relationship between a tendency to suffer from illusions of control and poor trader performance (including poor management of risk).

How might this relate to the causes of financial crises? One example back in the early 1990s is worth recalling. Peter Baring has been reported as telling shareholders at an AGM one year before the collapse of Barings’ Bank that, on the basis of the previous year’s performance, he had concluded it is easy to make money in the derivatives market. A year later the bank was valued at £1.

Any banker understands that there is a strong relationship between risk and return. Faced with unusually good financial performance in part of a bank’s operations, an important question to ask is “What hidden risks are we carrying that account for this high return?” However, faced with good returns, it is tempting to foster the illusion that good performance is a result of our unique skills and capabilities, while failures are due to events beyond our control. This tendency is known by psychologists as the self-serving bias.

This unwillingness to seriously question what hidden risks lay behind unusually high returns seems to have been an important factor in the recent demise of Lehman brothers and other major banks. A reckless love of money seems to have fuelled collective illusions about the risks being faced.

We need to understand more about how these kinds of emotion regulation processes work in financial decision-making. Current research is helping us understand these processes and how such blindness to risk can be reduced. The European Commission has funded me and an international group of researchers to conduct a major study looking at ways of improving financial decision-making. This study is looking at traders, investors and private citizens, and is paying close attention to the role played by emotions in their decision making.

Take it further

• Trading on emotion
• Has Robert Peston caused a recession?
• Bankers won, politicians lost

Further reading

Traders: risks, decisions, and management in financial markets, by Mark Fenton-O'Creevy, Nigel Nicholson, Emma Soane and Paul Willman, was published by Oxford University Press.

About the author

Mark Fenton-O'Creevy is Professor of Organisational Behaviour at the OU Business School. His research includes investigations into the performance of traders in financial markets, and the problems that occur when management practices are transferred from one country to another.

He is also a National Teaching Fellow, and Principal of the Centre for Practice-Based Professional Learning.

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What’s the difference between trading and investing? Investors have money which they invest; traders have very little capital but borrow in order to invest.

How can this be? The answer is easy. Traders borrow using the security of the securities they are going to buy! How does it work? Well suppose you think Marks & Spencer shares are going to rise in value. You buy them, then immediately pass them to a bank which in return provides cash. You then use this cash to pay for the securities you have just bought! This is called repo (short for ‘sale and repurchase’) and is exactly like secured lending. Everyone is happy. The lender has security in shares to cover the loan, and you have been able to borrow to speculate on shares rising.

But traders are not always bullish. Sometimes they want to bet on shares going down, In this case, the reverse transaction takes place. You sell shares you don’t own – called selling short. You immediately borrow the shares from another institution and hand them the money you’ve received from the share sale. When the price has – you hope – fallen, you buy back the shares at a lower price and close out your position.

Another way of speculating when you don’t have much capital is to use derivatives. These are synthetic securities which can be traded in the same way as shares, but where you only have to pay an initial deposit (margin) which is as little as 1% of the underlying value. If the price goes the way you have bet, then you need put no more money in, just take the profit when you sell the shares. But if the price goes against you, you have to top up the account to cover the losses on a day to day basis. But in general, derivatives allow you to leverage up by factors of 50 or more.

In recent years, hedge funds, who are investors in that they manage a pool of money, saw the profits that could be made through leverage and began to behave like traders. All went well until the credit crunch. But when things go wrong, leveraged traders can be wiped out very easily. The hedge funds run by Madoff used derivatives to enhance return supposedly without taking on too much risk. Yet anyone in the business knew that there is no holy grail. You can make fat profits in the good times only if you take on risk – and that means there is always the chance of going bust.

About the author

Janette Rutterford is Professor of Financial Management at the OU Business School, having previously worked in corporate finance and investment. Jannette's research includes pension funds, equity valuation and investment history, in particular the history of women and wealth.

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You might think the obvious way to make money in a recession is to be involved in the production or sale of low cost versions of essential items – such as pizzas, bread or pork sausages. But you can still get clobbered by rising costs – petrol, utilities and, when your staff have to pay higher prices, on rising wages too. A more indirect way is to be in businesses that positively profit from others’ distress – here the obvious ones are firms that specialise in sorting out the financial messes that individuals or companies get into. So, bailiffs and company receivers do well in a downturn.

A more straightforward way, though, is to make money indirectly through the stock market. In the old days, it was quite hard to do. If you held shares and the market went down, you lost money. Now, you can easily take a position which makes money when a share falls in price. You don’t even have to be a stock market professional.

Stock market figures.
[image © copyright Photos.com]

You can use futures or options – so called ‘derivative products’ which are linked to the underlying asset you want to trade. If you think, for example, that the FTSE 100 stock market index is going to go down, you can sell futures contracts on the index. Your brokers will require cash from you, to protect themselves if you are wrong, but essentially, you hope the index will go from say 6000 to 5500 and that what you sold at 6000, you can buy back at 5500, pocketing a profit of 500. The more futures contracts you sell, the bigger your profit.

"whether we are living in good times or bad, we can make money from the stock market"

Sounds too good to be true? The problem is – what happens if you are wrong, the FTSE 100 rises to 6500 and you have to buy back at a higher price than you sold? A lower risk way is to buy a put option. For a small premium, you have the option to sell the FTSE 100 say at 5750 when it is currently trading at 6000. If you are right and the index falls to 5500, you can effectively close out your position for a 250 point gain, less the cost of the put option. This way, if you are wrong, you can simply walk away, worse off only by the put option premium.

Investment professionals use futures and options to bet that prices will fall all the time. George Soros is famous for having made a fortune from selling the pound sterling just before it left the European Exchange rate mechanism. More recently, two traders at Goldman Sachs – Josh Birnbaum and Michael Swenson made money out of the ‘credit crunch’ – they sold products linked to the sub-prime market and bought back when prices had fallen. As a result, Goldman made around $4 bn from this strategy and Josh Birnbaum has set up his own $1bn fund trading sub-prime mortgages.

What can you do when markets have already fallen? The answer is invest in a so-called vulture fund which buys securities which have fallen dramatically in price, in the hope that they will recover. So, whether we are living in good times or bad, we can make money from the stock market. The only problem is getting your timing right!

Weblinks

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• How the FTSE is calculated
• Is the FTSE 100 biased?

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• You and your money: personal finance in context

The opinions expressed are those of the author and are not held by the Open University or BBC unless specifically stated. The material is for general information only and does not constitute investment, tax, legal or other form of advice. You should not rely on this information to make (or refrain from making) any decisions. Always obtain independent, professional advice for your own particular situation.

About the author

Janette Rutterford is Professor of Financial Management at the OU Business School, having previously worked in corporate finance and investment. Jannette's research includes pension funds, equity valuation and investment history, in particular the history of women and wealth.

Subscribe to Janette Rutterford's posts