May 21, 2003

Anderson Professor Examines Effects of Investor Psychology on Financial Markets

LOS ANGELES — An expert in behavioral finance and economics, Avanidhar Subrahmanyam, professor of finance at The Anderson School at UCLA, is known for his path-breaking research in the use of psychological principles to explain stock price movements. He argues that the effects of investor psychology on financial markets are heightened in a time of war, citing that during wartime a "mood of pessimism prevails," which reflects a depressed trading activity and stock market levels.

When examining the effects of war on the stock market, Prof. Subrahmanyam believes that human emotion plays a significant role in the health of the economy. In a recent article titled, "Rational Thinking Can Lessen Impacts of War," Prof. Subrahmanyam examines human emotions in relation to war and investing.

"Optimism fuels investment in risky assets like stocks. However, during wartime, when American citizens are engaged in combat, and we receive daily reports of past and eminent casualties, optimism is impeded. This is likely to cause depressed investment in stocks," Prof. Subrahmanyam states. "Even if a war has no direct impact on the economy, people will tend to have less of an optimistic outlook than in normal times, which in turn, will affect stock market levels."

He discusses the history behind economics and investor psychology and says that historically, economics have been based on the ideology that individuals are rational decision makers. Prof. Subrahmanyam claims that to truly understand market related behaviors, "we need to accept that humans are governed by a number of non-rational considerations."

On the subject of change in investment strategy over the past few years, Prof. Subrahmanyam believes investors have been shown to be subject to a range of biases such as overconfidence, extrapolation from small samples of evidence, and loss aversion (reluctance to realize losses). He also sees self-esteem issues as important factors in investment strategies.

"An investor may be reluctant to admit an erroneous investment decision, which may prevent correction of over-heated stock market valuations. Over the past few years, academic research, as well as the tech stock bubble's formation and bursting, have indicated to investors that irrational investing can cause a significant loss of wealth."

Prof. Subrahmanyam has most recently used his behavioral expertise to understand the spike in gas prices earlier this year. He notes that willing consumers are partly to blame for the jump in gas prices, explaining that they simply accept such rising gas prices because they associate them with the war with Iraq. Prof. Subrahmanyam also believes that oil companies and suppliers are opportunistic and capitalize on the market's perception. "Gasoline prices are affected by consumers likely to over-estimate the impact of war on the economy and producers raise gas prices knowing consumers are willing to pay higher prices in times of need," he said.

"In the context of recent events, consumer sentiment was low in recent times, but has picked up in April, suggesting that people are ready to put the war behind them. The increased confidence in our government to deal with the terrorist threat no doubt has also helped," said Prof. Subrahmanyam.

Regarding the future of investor behavior, Prof. Subrahmanyam notes, "I expect investors to be more careful and rational in the future. While this may cause volume trends to slow, stock markets may be less susceptible to the wild gyrations we have seen in recent years. In part, this is because behavioral finance research has made investors more aware of their biases and mistakes."

"The more we learn about our biases, the higher the standard of communication we demand from our leaders and the more we suppress emotional reactions to dramatic events, the better the functioning of our institutions and markets, and, consequently, the better off we are as a community," he said.

In addition to studying the effects of the financial markets, Prof. Subrahmanyam's recent research ranges from studying the relationship between the trading environment of a firm's stock and the firm's cost of capital, to behavioral theories for asset price behavior and empirical determinants of the cross-section of equity returns.

Dr. Subrahmanyam has authored numerous journal articles in a variety of scholarly finance and economics journals. He is a member of the Working Research Group on Market Microstructure, recently established by the National Bureau of Economic Research (NBER) in Cambridge, MA. He is a co-editor of the Journal of Finance and past associate editor of Review of Financial Studies. He has received best paper awards at the Western Finance Association meetings and the International Conference of Finance in Taiwan and has been nominated for the best paper in Journal of Finance. He has served as a consultant to the NASDAQ Stock Exchange, the National Stock Exchange in Mumbai (Bombay, India), San Jose Mercury News, and Irwin/McGraw-Hill.

Professor Subrahmanyam received his Ph.D. in finance from UCLA in 1990.

Contact Information

Media Relations , (310) 206-7707, media.relations@anderson.ucla.edu

Media Relations