Psychology of Financial Crashes

Most of the articles in this series on the psychology of betting have been concerned with our in-built cognitive biases, and how these can lead us to make poor punting decisions.  The message running through all of them has been that if we are able to, as punters, control our inner, irrational chimp.

Keeping things as they are

Sometimes, though, understanding human psychology has a value to punters beyond the insight it provides about our own thought patterns; often, it also allows a vital understanding as to how others will behave, too.

For example, understanding that humans tend to prefer the familiar over the new can help us comprehend how national referenda might play out. The public might say they want something, but do they really want it enough to risk what comes from changing from the status quo?

Psychologists tell us that, in most cases, they’ll choose to keep things as they are. They refer to it as status quo bias – a fundamental human desire that rejects change, instead favouring what we are accustomed to. We looked at the effect this bias was having on the way people vote in a previous article.

What we found, of course, was that in the last ten years, wherever you look in the political world, voters have seemed more than happy to break with what they know and choose a new path.

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Multiple factors at play

The US has seen the rise of the Tea Party and others political influences on the right, and, in two presidential elections, they have chosen candidates that represent a radical departure from what has gone before. In the UK, Scotland nearly chose independence, voters elected two hung parliaments, and the public instructed their government to remove them from the European Union. Catalans have twice voted for Independence from Spain and unilaterally declared independence from it in 2017.

Meanwhile, in Australia, whilst there has perhaps been nothing of the seismic nature of what’s happened elsewhere, there has, nonetheless, been a rise in the fortunes of right-wing politicians, with the likes of Pauline Hanson and Nick Xenophon gaining vote share in state and federal elections.

Wherever you look internationally, it seems, there has been political surprise and upheaval as a result.

The reasons for this willingness of voters to abandon the status quo are unquestionably complex, and we should be wary of attempts to reduce explanations to simple one-liners.  In every case, in every vote, there are multiple factors at play.

However, an academic paper published in 2015 by three German academics, Funke, Schularick & Trebesch, provides some compelling insights, which can not only help us understand what has happened in the last 10 years, but can also help us make better punting decisions in the future when it comes to these big political questions.

In their paper, Funke et al examine international data going back to 1870 and conclude that after a financial crisis – which they define as a recession sparked by some collapse within the banking sector – countries inevitably face political turmoil. They argue that voter behaviour changes, that governing becomes more difficult, and that protests and social unrest increase. With regards to voter behaviour, they specifically point to the public’s rejection of mainstream parties in favour of the far right, who enjoy, on average, a 30% increase in vote share after any financial crisis.

10 years later

So, does this provide an explanation for the tempestuous political climate we have witnessed internationally in the last 10 years?  Can we conclude that, whilst the status quo might be preferred in normal circumstances, voters reject it when they experience financial instability? Or, perhaps more accurately, that during fiscal collapse, what constitutes the status quo is impossible for voters to determine, so they naturally gravitate towards the right, who tend to blame change (usually in the form of immigration) for what has happened, and promise a return to how things were at some point in the past?

Maybe this explains why the tectonic political shifts witnessed around the world have been less dramatic in Australia: populist politics has certainly been on the rise, but not to the extent that has been seen elsewhere.

Australia experienced the 2008 financial crash in a different way to other developed nations, being one of the few to avoid a recession, perhaps providing an explanation for the more moderate political upheaval it has seen.

Also in the paper of Funke et al – and this is the bit of most interest for punters – is the conclusion that the political aftershocks of financial crises last for 10 years. In all previous examples, they conclude, the political effects diminish by this point, with variables returning to pre-crisis levels.

September 15th, 2018 will be the 10-year anniversary of the collapse of the investment bank, Lehman Brothers. This is seen by most commentators as the moment that national concerns around the US subprime market morphed into a full-scale international financial crisis. Will it also mark the date on which voters retreat from their reactionary behaviour of the last decade?

In Conclusion

Later this year, we will see congressional midterm elections in the US, federal and state elections in Australia, and continuing negotiations around Brexit. This might see voters given another chance to cast their vote on the future of Britain’s involvement with the European Union. Other elections and referenda are planned around the world.

As punters betting on these political decisions, do we need to take account of the approaching 10-year anniversary of global financial panic?

In the same way that the outcomes of public votes have provided constant surprise in the last decade in terms of the popularity of right-wing sentiment, I expect the reverse to now happen. We have already seen the beginnings of a rise of moderate, left-of-centre politics in by-elections in the US, for example, and I expect this trend to accelerate.

It is, of course, important to follow the specific issues around any public vote when deciding how to bet on its outcome. However, in the same way that opinion polls have failed to fully appreciate the strength of right-leaning sentiment in the last decade – with some commentators arguing that those answering pollsters have not been open about their voting intent – it is likely that there will also be a lag in how they take account of the emergence of new, centrist sentiment. You should build that expectation into what you consider value in these upcoming markets.

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