So I am a pretty awful golfer. I spend most of my time on the course, or rather off the course in the sand and fishing golfballs out of the water hazards, so naturally I do not hit many birdies or pars. However, pro golfers get paid to sink pars and birdies consistently. They don’t get paid for playing poorly, and so they only take risky shots when they are in a good position to do so. In a recent Moneyweb article, Cass R. Sunstein brought to light an interesting fact about pro golfers: when faced with a putt of equal distance and degree of difficulty, pro golfers sink the putt with a better percentage when the putt is for par rather than for birdie. This happens because pro golfers are loss-averse. They prefer to lay the ball up closer to the hole rather than risk missing the birdie putt, having the ball roll far from the hole, and then ending up with a bogey.
Sunstein made a clever connection between the volatility of the stock market and this behavior among pro golfers. He exclaims that a loss-averse participant in the stock market behaves a lot like a pro golfer in circumstances when market prices start dropping. These loss-averse investors will remove some of their holdings in order to limit their losses in the short run (like a golfer limiting their strokes on a given hole), but over time, these decisions to pull money out of investments hurt, as the small losses add up.
This behavior can spark stock market panics, like the one that occurred in February this year. Many investors start dropping stocks based on the behavior of other investors (by receiving “sell” signals via communication) even when metrics and the probability of gain are in the investor’s favor, resulting in the continued loss of value for a single stock or the stock market as a whole. Massive stock sell offs are an example of negative informational effects in cascading behavior. By following the information of others and becoming part of a cascade rather than following reason, the sellers often lose in the long-run, as more savvy investors, those who do not fall into the trap of a cascade, start buying the stocks based on fact and the stock prices go up. These informed investors are important for balancing out the market and preventing the cascade from causing a complete market failure.
We should not just take away from this the lesson that we need to just recognize informational cascades and rely solely on our own information. Rather, we, as future leaders, especially aspiring political leaders and economic experts, need to recognize the power that credentials have over the masses, and use this to not spread extreme emotions among the public, as heightened fear or excitement in a financial market can lead to crashes. President Franklin D. Roosevelt famously coined the phrase, “We have nothing to fear but fear itself”, recognizing that public confidence in the market was essential to avoiding detrimental informational cascades. However, overconfidence can lead to market bubbles, which can be equally harmful to the economy– for example, the housing bubble that burst in 2008.