Capital Markets Volatility: Surveillance And The Psychology Of Observation

All the news recently about the U.S. government’s telephone and online surveillance programs got ConvergEx’s Nick Colas thinking about a rich academic field: the psychology of observation.  How do observers differ from actual actors in their explanations of events they either witness or in which they actually participate?  Scores of academic studies point to a key difference.  Actors tend to attribute their decisions to situation-specific inputs.  Those observing these actions, by contrast, tend to ascribe their ultimate cause as tied to the personality of the actors involved.  Same destination, but radically different interpretations of the journey.  Even the process of being watched can change human behavior.  Bottom line – observers and actors are rarely on the same planet, let alone the same page, when it comes to explaining a given event.  Keep that in mind as you try to understand Fed policy, or a company’s management, or even your own family.


Via ConvergEx’s Nick Colas,

If you think your pet dog or cat is especially smart, consider the case of “Clever Hans”.  He was a horse owned by a German math teacher and horse trainer named Wilhelm Von Osten at the end of the nineteenth century.  Hans could do simple math, tell time, and both read and understand German.  Or so it seemed.  Ask him to add two and three, for example, and he would reliably tap his hoof five times.

Upon further inspection, it became clear that Hans was responding to subtle clues from his owner.  Small shifts in his stance, or even a change in facial expression from Von Osten, were enough to make Clever Hans stop tapping his hoof in response to a question.  There was no proof that his owner was trying to defraud anyone – he never charge for Hans’ performances, for example.  Hans was actually an exceptional animal, but in his ability to read his owner’s subconscious cues, and not anything else.

I thought about Hans when I heard about the U.S. Government’s cell phone and online surveillance programs last week.  The Feds are, of course, ticked off that their efforts are now public.  I assume those who wish to harm U.S. interests already knew their electronic lives are up for inspection, but the certainty of that fact will lead to greater caution on their part.  Knowing you are being observed changes human behavior, just as Clever Hans altered his actions in response to watching his owner.

The broader issue on this topic of interest to market participants sits under the same umbrella of how observers and actors are connected.  That’s the terminology used by psychologists, and the literature on the topic  – which runs into the hundreds of studies and papers – raises a few useful points for those of us who seek to understand capital markets behavior.  A few examples here:

  • In order to eliminate the chance for people to emulate Hans in psychological studies or drug trials, many follow a “Double blind” protocol.  Neither the subject (one “Blind”) or the researchers in contact with them (the other “blind”) know if they are receiving/administering a placebo or the pharmaceutical being tested in a drug trial, for example.
  • Psychologists who specialize in industrial productivity talk about the “Hawthorne Effect,” named after studies done at a Western Electric plant outside of Chicago in the 1920/30s.  Essentially what the research here found was that worker productivity improved when they were being directly studied.  Turn the lights up in a given part of the plant, and workers there became more efficient.  But turn it back down again and productivity took another bump higher, albeit temporarily.  Turned out that the folks on the shop floor were simply being motivated to better performance because management was taking an interest in their day-to-day conditions. 
  • Since the 1970s, one of the most widely studied phenomena in this field is “Actor – Observer asymmetry of attribution.”  Essentially, this theory says that decision makers  (“Actors”) and those who watch them (“observers”) maintain very different perspectives.  When asked why they made a decision, actors will generally point to specific situational causes.  The example from one academic paper: “I was quiet because I was at a funeral.”  Observers, on the other hand, will tend to attribute actions to their perceptions of the personality of the actor.  “He was quiet because he is introverted.”

The last point seems especially relevant to all of us watching the Federal Reserve and capital markets at the moment.  The question of the hour is, of course, when and how the Fed will reduce its bond-buying program, widely attributed to lifting U.S. stock to all time highs.  We as “Observers” spend a lot of time parsing the words and intentions of Fed speakers, including Fed Chairman Ben Bernanke, essentially to evaluate their personal thoughts on the matter.  At the same time, they – as “Actors” – view the question from an entirely different perspective.  For the Fed, it is all about “Specific situational causes,” to borrow a phrase from the literature noted previously.

Within this construct, capital markets volatility is the inevitable outcome of the “Actor – observer asymmetry.”  The Fed is, of course, doing its best to close the gap by communicating its thoughts as much as it can.  The problem here is that there are many different speakers, of course, and all in theory have input into the final decision of when and how to “Taper” quantitative easing.  Lots of actors will, logically, create lots of asymmetry, even if the Fed has laid out its numerical targets for economic progress.

As a former single stock analyst, I can’t help but think that the actor-observer problem is also essentially the crux of the challenge inherent in stock picking.  We gin up our financial models, do our Porter analysis and assess relative and absolute valuations.  At the end of the day, however, what we really want to know is what management will do to create shareholder value.  The individuals who run companies are still a critical part of the investment thesis, so you’d better understand their real motivations.

It is tempting to ascribe management missteps – and every company has them – to the personalities of the people making the poor decisions.  Maybe the CEO is a bit of a softy and therefore doesn’t cut costs enough going into a downturn.  Or perhaps the industry in question is heavily unionized and “Management doesn’t want to take on the rank and file.”  And when a company suddenly loses market share to a new competitor, “Management is too conservative and never invested enough in new products.”

All these explanations seem sounds enough, and I’ve even used a few of them myself over the years.  But they are also predictable actor-observer asymmetries and no doubt the management teams making the actual decisions could explain why they made them. They would, no doubt, feel that they did the best they could and “The Street just doesn’t understand our story.”

Summing up, the fact that observers and actors are so inherently disconnected seems an important lesson for a whole host of reasons.  Yes, it helps explain capital markets volatility.  The Fed is going execute on its gameplan – whatever that is – over the next year, and investors will see it as partly due to the personal biases of Chairman Bernanke and whoever succeeds him.  That will make it feel unpredictable to the point of being capricious.  But rest assured: the “Actors” at the Fed will not see it that way.

But remember the whole actor-observer thing the next time you quarrel with your spouse or partner or friend or a stranger.  Ask yourself if your perceptions of their actions are based on your assessment of their personality, or the facts they had on hand.  If you insist on using the former, you’re probably going to end up in a “Discussion.”  Try the latter first.


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