Monday, March 17, 2014

Role of Psychology in the financial crisis of 2007-2008

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This Subject interests me and hence i thought of putting this blog here.

Psychology played a critical role in explaining the “irrational behavior” of various financial institution entities which might have led to the subprime crisis of 2007-2008. this is a summary written on original  paper  by Nicholas Barberis.
Surge in the housing Prices:
The growth of the bubble can be attributed to the belief based theory of overvaluation where investors extrapolate past outcomes. Here in this case, the prior growth in housing price made the buyers believe that the growth will continue and bought houses with excessive loan to asset value ratio. Similarly, the financiers believed in the housing prices growth story and provided oversupply of subprime loans to buyers. These loans were securitized by complex financial innovations and sold to investors.  Here, this belief theory of extrapolation had its greatest impact where the security rating agency awarded risky assets with higher secure ratings. All this contributed to the surge in the asset prices.
Large Positions held by Banks in Sub Prime Linked Securities:
Manipulation of beliefs played a critical role in thwarting the cognitive dissonance which the various players (mortgage officials) would have felt while exposing the financial institutions to the high risked subprime linked assets. The complexity of the financial structure of these assets enabled them to manipulate their thought process through “bad incentives” - where they were incentivized to go for high growth funds and “bad models”  - where they modeled the financial future outflow to be a high growth one  and ignored the riskiness of the assets. Similar logic can be attributed to the security agencies which also gave higher ratings to these risky assets. Manipulation of belief ensured than Bank had great exposure to Sub Prime Linked Securities.
Dramatic Decline in the asset value:
With all confusion around the surprising and confusing developments in the market for subprime-linked securities, Investors including banks felt less competent while analyzing the subprime related assets as they incurred the initial losses in the risky assets.  This made them more ambiguity averse, leading them to reduce their holdings of risky assets, thereby further lowering the prices of these assets. Also the loss aversion amongst the investor increased as they incurred the initial losses which made them sell off the risky assets starting a downward spiral of asset values.
Belief based theories like Over Extrapolation over past experiences, Manipulation of beliefs to thwart cognitive dissonance and Ambiguity and Loss Aversions played a critical part in explaining all the 3 stages of the financial crisis – Surge in the housing prices, large positions held by Banks in subprime Linked Securities and Dramatic Decline in the asset values.

 Do let me know your thoughts on this.

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Thursday, March 13, 2014

Magic Lamps and Genie

Genie Lamps 1
Magic Lamp

In the Arabian nights, prince Aladdin had a Magic lamp. On rubbing the magic lamp, a genie used to appear and help Aladdin in achieving his wishes. As children we were mesmerized by the magic that happened to call the genie and its awesome capabilities of the genie.

By 2015, there would be more than 15 Billion connected devices. Social Media technologies – Facebook, Twitter, Hangouts are connecting people and devices together. Technological advancements in wearable technologies – Google Glass, Samsung watches, Fitbit Heatlh bands etc are innovating new ways of human interactions.  Smart combination of all these is changing the paradigm of how companies are approaching the customers. Magic is happening around us as these technologies are getting more evolved and more innovative

Now each device has become a Lamp itself. By Push of a button, we are seeing prompt customer services. For example, the “mayday” button of Amazon fire has response time of 15 seconds and 24/7 service. More and more equipment manufacturers are adopting having buttons in their devices to bring customer services to their customers literally to their fingertips. By this innovative move, they are removing the time consuming tele-calls and web logging processes. This is a trend which I think will usher the next generation customer service applications.

With smart use of social technologies, knowledge about products is getting dissipated to the customers at a greater ease and lesser cost. Apart from the reach, the collaboration helps in “crowd solving” the customer issues at a much cheaper cost. A onsite site defect can be easily photographed by the field personnel and shared to the offsite engineering team and solved realtime using wearable technologies like google glass, Samsung watches etc.

What we see is just the tip of the icebergs – The devices are becoming lamp, the technology is becoming the “genie “. I would like to end this summary with a quote from Charles F. Kettering  “Our imagination is the only limit to what we can hope to have in the future”
What do you thing. Please post your comments below.

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