The Power of Context

John Darley and Daniel Batson were two Princeton University psychologists who devised one of the most well-known social experiments of modern times, using the parable of The Good Samaritan to illustrate their point.

The experiment involved a group of theology students who were asked to prepare a seminar and then walk over to a nearby building to present.  Along the way, each student would pass an actor, slumped in an alley, pretending to be in distress.  The purpose of the experiment (unknown to the participants) was to see whether or not the students would stop.

Darley and Batson also split the group of students in two.  The first group were informed “it will be a few minutes before they’re ready for you, but you might as well head over now.” 

The second group however, were given a starkly different send off - “Oh, you’re late. They were expecting you a few minutes ago. We’d better get moving.”

The results of this study showed that of the first group, 63% of students stopped to help the man.  Of the second group, only 10% stopped to help.  In fact, in one instance, a student was actually on his way to give a talk on the parable of the Good Samaritan and actively stepped over the man in distress to get there on time!

This experiment shows the effect that context  has on human behaviour.  In the context of being in a rush, the behaviour of theology students differed greatly to those in the alternative context - having plenty of time to spare.  The intuition here is that as humans, we don’t behave in the same way (perhaps even rationally...) all of the time. Our behaviour is very much influenced by our environment.

The following is a clip from a meeting of the Institute of New Economic Thinking.  The speaker is Markus Brunnermeier, a leading academic in the field of financial crises, who gives some insight into the thinking of traders when it comes to financial bubbles.  He mentions a few of the concepts I've blogged about so far such as greater fool theory and indirectly, the Keynesian beauty contest.  I think it also shows how trader behaviour is altered when there is a change in context.  Rather than refusing to purchase assets that appear over-valued, traders consider purchasing in the context of a financial bubble.

The Tipping Point

Epidemiology is the study of how something spreads throughout a population.  Traditionally, the subject of such analysis is related to healthcare e.g. disease outbreak or surveillance but in 2000, Canadian journalist Malcolm Gladwell released his international best-selling book "The Tipping Point"  which examines how epidemiology can be used to understand how social phenomena can permeate through a population in the same way that viruses do.

Gladwell defines the tipping point as "the moment of critical mass, the threshold, the boiling point." That is to say, the moment when the idea really explodes.

He goes on to describe three rules of epidemics that lead to an idea reaching this tipping point and going viral:



1) The Law of Few



This rule states that there are three kinds of people needed for an idea to spread; connectors (who have wide social networks), mavens (information specialists) and salesmen (who have the power to persuade others).

Relating this to financial bubbles and specifically the recent US housing bubble, who could have taken on each of these roles?



Connectors - in my mind, this has to be the media.  Throughout the housing boom, news reports were positive about the housing market and television ads etc made the public very much aware of mortgage deals on offer.



Mavens - the technical experts in this case must be investment banks and other financial intermediaries who developed mortgage backed securities (MBS) and pricing models.



Salesmen - in this case, they could be those who sold mortgages to the public in the first place.




2) The Stickiness Factor



This rule addresses how sticky  the idea is.  I think earning great returns on an investment is probably about as sticky  as it gets - the chance to live the American dream!




3) The Power of Context

(I'm going to put this in a separate post)


Whilst Gladwell has come under some criticism for this theory, it does seem to add up in this case: banks develop a method of securitization involving property and increase activity in the market.  House prices begin to rise and the news starts to make headlines.  The public become aware of the news and confidence in house prices rises.  Then the institutions that offer mortgages find new products and attempt to outdo each other by offering 125% mortgages etc.  House prices rise and rise and the idea that this is a safe investment and a great way to make money and improve lifestyles spreads.  And this idea travels further and further through society to a point where everyone has a big mortgage and anyone with large savings is interested in property development.  And so the bubble expands as the idea works its way through the population.  From the graph below, there looks to be a tipping point at around the same time Gladwell's book was published in 2000.

A similar tipping point  then occured in 2007, when the market went the other way, as beliefs were reversed.

Social Proofs

Social proofs form the basis for the term herding, which has become popular when describing financial bubbles. 


In his book Influence: The Psychology of Persuasion, Dr Robert Cialdini devotes an entire chapter to the power of social proofs.  The concept comes from a human awareness of the views of society as a whole and a reliance on the wisdom of crowds : the idea that if an opinion is held by a majority, it is likely to be the right one.  This feature is amplified in times of uncertainty; if a person has difficultly coming up with their own decision or view, they will comply with others more easily.






Cialdini recalls both incidents from the public sphere as well as experiments carried out by psychologists,who collect empirical data to show the biases asserted by individuals when placed in a group.  The strongest examples are particularly dark, describing the mass suicide of The People's Temple at Jonestown, Guyana ; where in 1977, 910 people drank from a vat of strawberry-flavoured poison and the murder of New York citizen Catherine Genovese in 1964; where 38 witnesses failed to call the emergency services.

Dr Robert Shiller

Extending this line of thought to financial markets has been the work of Robert Shiller.  In 2005, Shiller teamed up with Karl Case and surveyed new home buyers in San Francisco and found that the average person expected house prices to continue rising at a rate of 14% per year for the next decade.  Indeed, about a third of respondents expected to see a 50% rise in house value per year.  As these people were not market experts, this example shows how housing market optimism had become the socially accepted position and contributed to a housing bubble.