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Behavioral Causes of the GFC

As incredible as it is to think about, we’re closing in on 10 years since the global financial crisis (GFC) of 2007 – 2008 that saw the housing market collapse lead to an almost complete breakdown of capital markets worldwide. Overnight several banks failed, with the rest forced to admit to a shaken public and a nonplussed federal government that they needed assistance to get back on their feet.

While the banks and many private citizens learned painful lessons during the collapse and ensuing recession, history continues to paint a fascinating picture of what happened to cause the bubble, particularly when it comes to the areas of psychology and behavioral finance.

In 2011, Yale’s Nicholas Barberis penned “Psychology and the Financial Crisis of 2007–2008” in which he addressed the crisis from an emotional angle and came up with three root causes:

• Over-extrapolation of past resultants
• Self-inflicted belief manipulation
• Psychological amplification mechanisms

In some ways, that’s a lot of fancy talk for people acting on what their hearts,­ and often their greed,­ said as opposed to what their brains were frantically trying to tell them. But doing a deeper dive into the reasons behind such a massive brain freeze is worth exploring, lest they be repeated.

If you’ve ever lived in a booming metropolitan area, you know all about over-extrapolation. Governments will watch populations rise and start planning long-term for more schools, more roads, more everything, only to have to dial those estimates way back when the population eventually slides back to a stable curve.

This is the basic theory that happened in the housing market. Historical data suggested prices were only to keep going up, even though at its root, that type of theory breaks the most fundamental of economic principles–every market and product has a tipping point. Here however, investors believed the date of saturation was a long way off, leading to the aforementioned over-extrapolation. In this bullish market, investors kept buying, assuming prices would go increasingly up thus resulting in an unsustainable price bubble.

Belief manipulation sounds like an euphemism for lying, but it’s more complicated than that because it involves professionals and experts in a field lying to themselves in order to make their shareholders, investors, and companies happier and wealthier, at least until the bottom dropped out. No one wants to be a spoiler when a party is going ahead at full blast and this is pretty much what happened with the professionals too.

The psychological amplification mechanism describes the process by which investors focused solely on home mortgages because they had met with previous success there and they knew, or thought they knew, how the process worked. Barberis broke the mechanism down into two components: Loss aversion and ambiguity aversion.

Loss aversion is fairly simple–if investors have lost money in some particular realm in the past; they are unlikely to return there in the future. Ambiguity aversion is a close cousin; if investors don’t really understand a market, or why it moves up or down, they’ll avoid it. So again, investors stuck with what they knew–home mortgages–and kept funneling all their business that way, eventually dooming themselves and their banks.

A lot of finger pointing got done in the weeks and months after the full financial collapse came to life, but this does not mean that we can absolve ourselves from any personal responsibility to make sound financial decisions.