Money Minded: How to Psychoanalyze the Stock Market

Avid Reader Richard Peterson used his psychiatric training to build software that analyzes investor behavior. He’s founded a hedge fund based on the results. John Gilhooley

There's just no nice way to say it: You're stupid with your money. You may fancy yourself a shrewd investor, but if you have normal human instincts—if you stand up and cheer at sporting events, if you follow the crowd toward the exit at the theater—then you have the instincts that make investors alternate between delirious greed and inconsolable fear. Like most of your peers, you are wired to buy high and sell low, and that's why Richard Peterson is about to become one very rich psychiatrist.

When the markets reopened after September 11, 2001, insurance stocks plummeted as investors sold them in a panic. Even Berkshire Hathaway, Warren Buffett's icon of caution and profitability, suffered a 9 percent drop over 10 days. (It owns a major insurance company.) A shrewd, heartlessly rational investor watching the sell-off would have calculated the long-term value of Berkshire Hathaway and realized that he was getting a great price on a great stock. Buying on September 19 at $61,400 per share, he would today be holding a stock worth more than $149,000. But at the time, the market was in the grip of emotion, not reason. Most investors decided to run for it.

Since the 1980s, psychologists, neurologists and psychiatrists have tried to apply their understanding of this kind of human behavior to the financial markets. These "neuroinvestors" are trained to diagnose phobias, compulsions—and, they hope, financial irrationality. They want to understand why, whether the market is headed into the ground or up to the heavens, everyone does the wrong thing, all together, pretty much all the time. And they aim to help the clever few profit from the synchronized panic of the investing public.

Peterson, a rapid-speaking 35-year-old Texan, may be the first person to have gone to medical school with the express purpose of learning to diagnose financial markets. "I didn't put it in my application," he says, "but I was looking for qualitative and emotional explanations for the way the market moves." Now, having helped develop software that tracks the language with which reporters, analysts and bloggers talk about stocks in order to identify missed opportunities, Peterson, along with a professor of accounting and a Web entrepreneur he can't name, will in March launch his own hedge fund, MarketPsy Capital, based in California. The fund will make money by using psychiatry and technology to understand and exploit human idiosyncrasy.

Tell Me About Your Past

At first glance, neuroinvesting looks like a bunch of Ph.D.s selling empty psychobabble to stockbrokers. But it's the result of three centuries of work. From classical scholars like Adam Smith, who in 1759 described the ways in which humans influence one another's behavior, to neoclassical 20th-century economists such as John Maynard Keynes, who worked to link individual choice to larger economic trends, philosophers and economists have long sought to connect the vagaries of free will with the patterns of moneymaking.

Only after the 1960s did the study of psychology become varied enough to have practical applications outside of mental health, and then, in 1979, a pair of psychologists, Amos Tversky and Daniel Kahneman, published the founding paper of neuroinvesting. Entitled "Prospect Theory: An Analysis of Decision under Risk," it articulated the process by which people wring their hands over risky decisions—that is, financial ones. (Later, Kahneman would win the Nobel Prize for his work.)

Tversky and Kahneman posited that people tend to use irrational standards for evaluating uncertainty, and that those standards don't fall in line with true probabilities. A classic example of such irrationality is weighing a stock's current price against the price you paid ("I can't sell at $42. I bought at $50!"). It's illogical—one should calculate whether a stock is worth its current price, rather than making decisions based on hope and regret—yet every trader has done it.

Their theories remain central to most work in the field. When people have to make decisions without enough information, the way they think changes fundamentally. With sufficient information, we're clear-headed. But investment decisions are made under pronounced uncertainty. As the amount of available information declines—the very moment investors should be analytical—people instead go with the vibes they pick up from everyone else. In short, when information is sparse, we stop using our highly tuned, very fancy human brain and go back to our good old reliable animal brain. And animals are terrible investors.