Question

1. What role did irrational investors play in the financial crisis of 2007/2008?

Answer 1

Irrational investors played a significant role in the financial crisis that unfolded in 2007/2008. Investors, during that time, exhibited a herding behavior. This was exhibited from all sorts of investors like commercial banks, S&Ls, investment and insurance firms and even retail investors. These irrational investors were blinded by their greed and hence ignored the tangible risk to a great extent. Irrational investors made cognitive errors and become blinded to the risk that stared them in their faces. For example executives of Merrill Lynch were encouraged to be aggressive in their dealings and this boosted the company’s exposure to sub-prime mortgages. The advice of the company’s risk managers was blatantly ignored. The company’s CEO – Stan O’ Neal – constantly prodded the company’s employees to take on more risk. All these led to cognitive errors from the investors and they ignored disconfirming evidence that was gathered by them. There was a widespread climate in which everyone was looking to enhance their wealth and position. This led to irrationality based on false exuberance and this irrationality played a very important role in the financial crisis that unfolded in 2007/2008.