The New Frugality

Will 2009 be the year we finally learn financial common sense? History and the emerging field of behavioural finance suggests that we won't.

"Once in a while, (the market is) rational," said Hersh Shefrin, professor of behavioural finance at Santa Clara University. "But we are very vulnerable to our emotions wrecking havoc."

Shefrin tries to understand human behaviour in the financial markets by looking at finance, economics and psychology as a whole. What he sees isn't pretty.

Last year "we learned that a lot of supposed financial experts had no clue what they were doing and that what lies beyond greed and fear is irrational exuberance and panic," he said.

Or as one student wrote in an online paper: "Risk resides not only in the price movements of dollars, gold, oil, commodities, companies and bonds. It also lurks inside us – in the way we misinterpret information, fool ourselves into thinking we know more than we do, and overreact to market swings."

Tom Velk, economics professor and chair of North American studies at McGill university freely admits that classical economists are fallible.

"They get it wrong sometimes because of bubbles, speculation and foolishness," he said. 

"These waves of irrationality are for a psychologist to explain. But it seems to sweep the population.They shouldn't have the idea they'll turn $10 into $100 overnight. You just can't make money that fast." 

But bubbles, booms, and busts emerged right alongside the first modern market. Traders in  17th century Holland experienced the first speculative bubble.

In 1636, the tulip was a rare and coveted commodity made even more precious by the presence of a the mosaic virus - a disease that infected the flowers and made them more beautiful and delicate than today's varieties.

Prices rose to where one bulb of the beautiful Viceroy flower was recorded as being traded for the price of four fat oxen.

"The price of these things grew astronomically," said Mike Dash, journalist and the author of  Tulipomania. "That you could make a lot of money by putting a bulb into the ground and sitting back for six months seemed like a great idea."

Speculators needed only to leave a 10 per cent deposit to acquire a bulb and trading traditionally took place in taverns under a haze of inebriation.  

"The mania sucked in so many people," he said.

When the bubble burst, growers were left with worthless flowers and many merchants - who had mortgaged the tools of their trade to buy into the market - faced bankruptcy, forcing the Dutch government to intervene. In May 1638, a government commission ruled that tulip contracts could be annulled if buyers paid 3.5 per cent of the agreed upon price.

"There are clear things you can see paralleled today," Dash noted.  "The key one is greed - you can get something for nothing."

George Grantham, associate professor of economics at McGill University calls it the casino instinct.

"Individuals are not rational all the time," he said. "When a lot of people aren't rational at once - that's where the bubble occurs. There's a tension between the short-run and the long run. When faced with the possibility that in two or three months you'll be rich beyond you're wildest dreams, the short view will dominate."

Examples of this casino instinct litter the last four centuries of economic history. The Mississippi bubble from 1719 to 1720 , when a monopoly on trading rights in the French colonies promised 120 per cent profit for shareholders, the Vienna stock market crash of 1873 caused in part by overbuilding in railway construction, the bull market of the roaring 1920s that boasted a new era of economic fundamentals, and the Japanese bubble economy where one square metre of land in the trendiest part of Tokyo went for $1.5 million U.S.

Lesser examples include Sweden's housing bubble and the dot-com bubble of the 1990s.

People always jumped at the chance to make a quick buck.

"It's like that in a bubble, people become very short sighted," said Grantham. "It affects your brain.There's a lot of psychology involved in this. If you were successful in the early stages, you could walk away with tens of millions of dollars. The incentive is there to jump in and join the ride."

But booms come with busts and panic buying comes panic selling.

"Buying as if trees will keep growing clear to the sky gets us into these messes," said Shefrin."What gets us out, usually with a lot of pain, is enough people waking up and suddenly noticing that the trees have stopped growing."

Bankruptcies, recessions, depressions follow on the heels of the buying mania. We become fearful mattress-stuffers instead of spendthrifts. 

"Maybe we'll all just get more sensible for 10 years and that'll do it," said Velk. "Maybe for a while we'll have to hunker down and take it."

So is it time to accept that frugality is the new black and we're forever doomed to repeat our mistakes?

"Yes," said Sherfrin. "Unless people learn the lessons of behavioural finance and how to put those lessons into practice."

Happy hunkering.