Money Minded: How to Psychoanalyze the Stock Market

By the mid-1990s, investment houses had begun to put these kinds of ideas to work on the market. Firms like Fuller & Thaler Asset Management, founded by economics and behavioral-science professor Richard H. Thaler, one of the most visible academics in the field, were hailed for applying psychology to investor behavior, creating investment models based on psychological assessments of biases and other intangible factors. One might assume that given their particular expertise, the neuroinvestors were ready to take advantage when market participants, almost all at once, stopped reasoning and started blindly doing what everybody else was doing. They should have been prepared, in other words, for the Internet bubble. But during the dot-com bust, prominent behavioral-finance funds, including one that Thaler advised, generally either stayed out of the fray or suffered the common fate.

Of course, it's not that Thaler and his peers failed to spot dot-com irrationality. They knew it was all nuts. But it's one thing to know that insanity has taken hold, and another to predict when the stampede will subside so you can profit off the return to normalcy. The neuroinvestors, like everyone else, weren't able to predict when their clients should walk away from the table.

The problem was that their models were too vague. "There's been more progress on the individual cognitive psychology over the last 20 years than on mass psychology," Thaler told the New York Times in 2001, at the end of a down year. "If we had a model that would have been able to tell us when the Internet bubble would break, believe me, we would have used it . . . But nobody has the tools, at least as far as I know, that allow you to forecast these changes in these moods." Peterson thinks he may have exactly those tools.

How Does It Make You Feel?

His father was a professor of finance, and Peterson grew up talking about the stock market at dinner. As an undergraduate, he studied electrical engineering at the University of Texas, and in his senior year he built a piece of statistical software for predicting stock performance. "I found that mechanical systems were most correct when I was most reluctant to believe them," he remembers. "When it said ‘Sell,' my reaction was always ‘What? This thing is going to the moon!'"

Looking for a deeper understanding of investor behavior, he applied to medical school in 1995, and in his off-time at the University of Texas he busied himself with further investment experiments. "I started trading on my intuition, and my performance dropped dramatically," he says. "On paper I was 70 percent accurate, but trading my own money"—which is more nerve-wracking—"I was 30 percent accurate. I figured I needed to understand my emotional state." He began to watch conversations about investing on early Internet message boards. "I looked at the language that was making people buy stocks."

Peterson embarked on his psychiatric training at a time when behavioral finance had fallen out of favor on Wall Street, and he began reevaluating the model. As he sees it, the rise of high-speed computing and new forms of analysis make it possible to pursue a more sophisticated form of behavioral finance. "Younger academics are being taught experimental techniques and statistical tools that create good ways to run real experiments," he says.

A wave of research like Peterson's—made possible in large part by the widespread digitization of data and the ready availability of powerful computers—is on display in new publications like the quarterly journal of the Institute of Behavioral Finance, founded in 1998. Its contributors are drawn from all over the worlds of finance and academia, and they're all trying to pin down a very nebulous subject.

Much of the research relates to risk aversion and the ways it gets investors into trouble. A 2001 paper by Robert Prechter [see preceding page] uses neurological theories about the difference between the neocortex (which is thought to control reason) and the basal ganglia and limbic system (instinct and the emotions) to conclude that our instinct to pursue acceptance and alliance—"herding"—while helpful for survival in the wild, is counterproductive in investing. On the market, so few people know what they're talking about, Prechter argues, that following the loudest opinion just sets off a mindless stampede. Just ask Warren Buffett, who was trampled after September 11th even though events didn't damage his company's fundamental value.